Homebuyers often misunderstand how the Federal Reserve affects traditional mortgage rates. Here is the reality: the Federal Reserve does not actually set mortgage rates. Instead, it determines the federal funds rate, which in turn impacts shorter-term and variable interest rates.
When the federal funds rate is cut, it becomes less expensive for banks to borrow from other banks and in theory, those “savings” can be passed on to consumers in the form of lower interest rates on lines of credit – including mortgages.
In other words, the Federal Reserve’s efforts to ease interest rates also pump up housing, because more people can afford mortgages. That sounds like a great win for most everyone.
But what happens when the Fed stops cutting rates? Or raises rates? Mortgage rates head up.
The Fed in 2019
The Federal Reserve has been busy during the summer and fall of 2019 as it takes steps to prolong what has been the longest economic expansion in history.
- In July of 2019, the Federal Reserve cut interest rates for the first time since 2008.
- In September of 2019, the Federal Reserve cut interest rates for the second time.
- In mid-October of 2019, the Fed announced its intent to buy short-term Treasury debt at an initial pace of $60 billion a month.
Further, the market is predicting – with a probability of more than 94% – that there will be another quarter-basis point rate cut at the October 30th Fed meeting, according to the CME’s Fed Watch tool.
Not Qualitative Easing
“This is not QE,” said Fed Chairman Jerome Powell. “In no sense is this QE.”
So, Fed officials say this bond buying program is nothing like the “Qualitative Easing” bond-buying stimulus campaign unleashed by the Great Recession of 2008. Homebuyers may remember the average 30-year mortgage rate was more than 6% in 2008.
Yet, whether you call it Quantitative Easing or not, the Fed’s decisions in 2019 have kept the economy humming and held down long-term interest rates, while supporting stock markets in the U.S. and in other parts of the world. At least for the moment.
But the Fed can’t cut rates forever. In addition, the Fed has stated that it will end its bond buying in the second quarter of 2020. When that happens, homeowners and potential buyers cannot expect low mortgage rates to continue.
We may have seen this movie before.
As it stands today, rates are close to historical lows. In fact, over the past 50 years, rates on the 30-year fixed-rate mortgage have ranged from as high as 18.63% in 1981 to as low as 3.31% in 2012.
But according to BankRate, on October 17th – two days after the Fed announced its intentions to buy bonds by the way:
- The benchmark 30-year fixed-rate mortgage jumped to 3.92% from 3.77%
- A year ago, it was 5.01%
And five days after the Fed announced its bond buying programs, the National Association of Realtors released this: “Existing-home sales receded in September following two consecutive months of increases. Each of the four major regions witnessed sales drop off last month, with the Midwest absorbing the brunt of those declines.”
Is it possible the mortgage and housing markets are anticipating the end to rate cuts and bond buying?
What Happens When Rates Jump?
Consider why a prospective homebuyer pauses when rates jump. A homeowner shopping for a $500,000 house and making a 20% down payment purchased a home with a 3.50% rate and a $2,317 monthly payment, including property taxes.
Now, with a 4.42% mortgage rate, the same house costs 7.6% more on a monthly-payment basis, or an additional $176.
Other markets affected by changes in mortgage rates:
- Rising rates curtail some new purchases but also hit hardest at refinances, which dry up as rates increase.
- Rising prices also concern prospective buyers. Housing affordability hinges on income and mortgage rates. Most buyers finance their purchase and shop for a house based on how much they can afford each month.
The Largest Purchase You’ll Likely Make
If you’re entering the housing market, ask yourself what will happen when mortgage rates rise.
And more importantly, remember the one positive lesson out of the Great Recession: Your home is not an investment.
It’s a roof over your head, a place to welcome friends and family. It’s an expression of your personality and likely the largest purchase you will ever make.
It is much more than an investment.