The current high inflation and mortgage rates crisis affects both home sellers and buyers. Many ask: How interest rates affect the housing market?
We got answers that will teach you how mortgage rates work.
KEY TAKEAWAYS
- Learn what interest rates are and how they work.
- Find out how interest rates affect the housing market.
- Understand how mortgages work.
- Learn how mortgage rates are determined.
- Find out how inflation impacts the housing market.
- Finally, how the Fed intentionally increased interest rates to force home sellers to lower prices to control runaway inflation.
How Interest Rates Affect The Housing Market
Several players affect interest rates:
- Banks and other lenders;
- The federal government; and
- The mortgage industry.
Also, local, national, and global economic conditions drive prices up or down. Prices often depend on supply and demand. Inflation affects prices by reducing the strength of the local currency.
Let’s explore these factors and how they affect interest rates.
What are Interest Rates?
According to Investopedia, an interest rate is an amount charged by a lender on top of the principal amount loaned to a borrower. Banks and other lenders charge different interest rates determined by several factors including the country’s economic health,
Central banks for every country sets interest rates used by their banks to determine the Annual Percentage Rate (APR) they charge.
Tip: High inflation usually triggers central banks to raise interest rates to discourage borrowing to lower consumer debts.
How do Mortgages Work?
Our mortgage industry has three players: mortgage originators, aggregators, and investors. Here’s an explanation of each player.
The Mortgage Originator
Lenders are called mortgage originators. They consist of banks, credit unions, and private mortgage companies. They create, market, and sell loans to consumers. Also, they compete against each other based on their fees, interest rates, and services. Their fees and interest rates determine their profit margin.
Mortgage originators often sell the mortgage to the secondary mortgage market instead of selling the mortgage themselves. Similar to manufacturers selling to wholesalers who then sell to retailers. Each player has a profit margin.
The Aggregators
The aggregators buy original mortgages in the secondary mortgage market. Often, aggregators pool mortgages into Mortgage-Backed Securities (MBS).
The MBS is a bond backed by a pool of mortgages sold to investors. Both parties will factor in their profit margin.
The Investors
MBS investors include:
- Banks;
- Foreign governments;
- Hedge funds;
- Insurance companies;
- Mutual funds;
- Pension funds; and
- Government-sponsored enterprises like Fannie Mae and Freddie Mac.
Investors try to maximize returns by running relative value analyses between the MBS and fixed-income investments like corporate bonds. The analysis determines the price they are willing to pay for each MBS.
How Are Mortgage Rates Determined?
Two different opinions exist amongst economic experts regarding how mortgage rates are set.
1. Investopedia
According to Investopedia, mortgage rates are determined by what investors pay for the MBS and then offer to the consumers (home loan borrowers).
Yet, Investopedia additionally points out that mortgage rates are also influenced by what the free-market price investors are willing to pay. Then, these prices filter down to the interest rates that consumers pay for their mortgages.
2. Bankrate
Contrarily, Bankrate claims that the federal funds rate and 10-year bond rate determine mortgage rates. According to Bankrate, it all begins with the U.S. Federal Reserve (our Central Bank) known as the “Fed”. The Fed sets the interest rate that banks charge when they lend money to each other.
Known as the “benchmark rate” because it’s used by banks to set their loan interest rates for borrowers. Everything from credit cards to savings accounts use the benchmark rate.
Also, U.S. government 10-year bonds set their interest rates based on the benchmark. According to Bankrate and other experts, it’s this rate that influences mortgage rates. According to Bankrate:
Recap: The higher the benchmark rate, the greater the mortgage rates resulting in higher monthly payments for home buyers.
Got Questions?
How Inflation Impacts the Housing Market
Inflation causes the price of all goods (including homes) to rise.
Investopedia explains the “relationship between inflation and interest rates” as moving in similar directions due to interest rates used by the Federal Reserve to control inflation.
When you borrow money, you must pay an interest rate that compensates the lender. Interest rates control credit supply and demand. Higher interest rates create less demand for loans.
Recap: Inflation affects interest rates by driving the rates up. This causes borrowers to stop borrowing because it’s too expensive.
What The Fed Is Doing To Combat Inflation
The Federal Reserve (Fed) is playing a large role with inflation expectations.
The Fed is attempting to lower inflation by raising interest rates to force consumers from borrowing and getting further into debt. The more it costs to borrow money, the fewer consumers will borrow. However, this takes time. Probably well into 2023 to take effect.
Thus, home prices rapidly rising in 2021 and early 2022, will now begin to fall as fewer buyers can afford to borrow on mortgages. In 2023, the Fed hopes that home prices will become more affordable.
When mortgage rates rise, buyers’ monthly payments increase forcing home sellers to lower their prices. For example, a 4% interest rate on a $250,000 mortgage costs $1,194 per month. A hike to 6% interest makes the monthly payments increase to $1,440 (a 20% rise). It’s even worse now that mortgage rates are around 7%.
Time Magazine recently summed it up: “The Fed hopes its rate hikes will temper demand for consumer goods and services by making it more expensive to borrow money.”
Recap: It’s all about Supply & Demand economics. Rising mortgage rates reduce buyers’ purchasing power. When buyers can’t afford expensive homes, it kills demand and drives down prices.
How Interest Rates Affect The Housing Market – Conclusion
We covered much ground explaining: How Interest Rates Affect The Housing Market.
You learned:
- What interest rates are and how they work;
- How interest rates affect the housing market;
- The way mortgages work;
- How mortgage rates are determined;
- How inflation impacts the housing market; and
- The Fed intentionally increased interest rates to force home sellers to lower prices to control runaway inflation.
Find a Trusted Realtor in San Diego
With such a volatile real estate market, if you are thinking of selling or buying a home in San Diego County, find a trusted Realtor to work with. A good Realtor knows the local area and its real estate market. Your Realtor will give you insight that you can’t find on the internet.
Sellers
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Buyers
Similarly, your local Realtor can help you to find your ideal home and negotiate a fair price with the seller. Our unique RealScout tool also helps home buyers find their ideal listed home faster and even arranges a quick viewing of the home.
Read our “RealScout Comes to San Diego to Help Home Buyers” article to learn how it works for you.
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Contact us today to find out how our unique tools like RealScout help home buyers and sellers in today’s fluctuating housing market.
Steven Rich, MBA – Guest Blogger
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Steven Rich, MBA has been involved in the real estate industry for over 30 years. As an investor, real estate agent, associate editor of a real estate magazine, a real estate marketing expert, a Wikipedia real estate article author, and as a writer.
