Interest rates have a significant impact on our economy, the stock market and the real estate market. The central bank of the United State – also known as the Federal Reserve – is in charge of maintaining economic and financial stability. They work hard to keep the economy thriving by raising or lowering the cost of borrowing money, which has a very significant impact on your wallet. While the committee looks at a broad range of data and economic indicators when making their decision about interest rates, they really pay attention to employment numbers and inflation. Basically, the way it works is that when the economy slows down, or looks like it may be taking a pause, the Federal Reserve may choose to lower interest rates in an effort to incentivize businesses and individuals to invest more money, hire employees at small business and spend more freely to encourage growth. On the other hand, if the economy is really taking off and growing fast then the Federal Reserve may increase rates, which can cause employers and consumers to pump the breaks on any big financial investments and decisions.
Historically, the Federal Reserve will aim to keep interest rates at a healthy 2.0% to 5.0%, which indicates a thriving and stable economy. However, the all-time low is zero, and the Fed has lowered the rates to a range of 0.0% to 0.25% twice – once during the financial crisis in 2008 and once in March 2020 during the global Coronavirus pandemic. After the first significant drop in 2008 rates were not raised again until December 2015, when the economy significantly improved, and unemployment rates steadily declined.
There are many ways that interest rates can affect you as a business owner, a consumer and as a potential buyer looking to enter the real estate market. Here are four ways that you can expect the Fed to impact your wallet and savings:
- Credit Card Rates
Most credit cards operate with a variable interest rate, which is tied to a prime rate (the rate that banks award to preferred clients who have a good credit score). The prime rate however is based on the Federal Reserve’s key benchmark tool – the federal funds rate. In other words, when the Federal Reserve lowers or raises the benchmark interest rate, the prime rate will also fall or rise with it. This means that interest on credit card balances will also fluctuate and it can significantly affect your budget and payments.
- Savings Accounts
If you have all your life savings stored in an account at a bank, then you have the opposite priorities of a borrower. While someone who uses their credit card often will aim for a lower interest rate to keep their payments low, a saver will celebrate when the Federal Reserve initiates a rate hike and take a big hit when rates are slashed. Additionally, banks usually choose to lower the annual percentage yields (APYs) that are offered on their consumer products like savings account whenever rates are cut.
- Mortgage Rates
You may be surprised to learn that mortgage rates are not directly tied to the decisions the Federal Reserve makes in regard to interest rates. Interest rates on home loans are more closely tied to the 10-year Treasury yield, which is the benchmark for a 30-year fixed mortgage rate. This means that just because the Fed slashed rates to nearly zero just two months ago, interest rates for home loans did not drop down to zero. Another example to take into account is that the Federal Reserve hiked rates four times in 2018, but mortgage rates declined throughout the year into late December.
- HELOCs
If you hold a mortgage that has a variable interest rate, or you are looking to take out a home equity line of credit (HELOC), then you may feel more of an influence from the Fed than if you hold a traditional fixed rate mortgage. Interest rates on HELOCs are tied to the prime rate, which means that if the Fed raises or cuts rates, then the HELOC rate will adjust accordingly.
How Interest Rates Affect Spending & Buying
Every time a borrower takes out a loan there is always the chance that they cannot or do not repay the money. In order to compensate for this risk lenders tie interest into the loan to ensure that they earn some money on the loan as the borrower slowly but surely repays it. The lower the interest rate, the more willing consumers will be to borrow money so they can make big purchases like cars or houses. When consumers receive a low interest rate, they end up with more money to spend, which in turn creates a ripple effect of increased spending throughout the economy. In this scenario businesses also benefit from low interest rates because it encourages them to invest more money into their business due to the low cost of borrowing and in turn output and productivity can increase.
On the other hand, when interest rates are high it means that consumers won’t have as much disposable income and will need to curb their spending habits. When high interest rates are paired with strict lending standards then the banks make and offer less loans. This means that not only are consumers spending less money, but businesses are also cutting down their spending and reducing their output and productivity.
It’s important to understand that The Federal Reserve doesn’t actually set mortgage rates for buyers. Instead, it determines the federal funds rate, which impacts short-term and adjustable interest rates. This rate is the one that financial institutions use to lend money to one another. When the federal funds rate increases it becomes more expensive for banks to borrow from other banks and then these higher costs are passed down to consumers in the form of higher interest on lines of credit, car loans and mortgages. As rates rise this could mean that getting a new mortgage loan could come with a higher price tag. Even the smallest fluctuation in interest rates can have a very significant effect on costs for buyers. This could also have an effect on rentals because if potential buyers choose to continue renting due to high borrowing costs then this additional demand could drive up rent prices.
Interest rates also have a profound effect on the value of real estate, in addition to the supply and demand for properties. Rising interest rates could significantly suppress home prices and bring them down. Because a higher interest rate makes a mortgage less affordable on a monthly basis then sellers could be forced to drop their prices in order to attract buyers. This could be a great opportunity for buyers who are looking for a great deal on a property, especially because the option to refinance the mortgage is always available if rates drop.
There are many different mortgage options available to buyers who are interested in entering the real estate market. It’s important to go over all of the options with a trusted and experienced lender who can walk you through the process of applying for a loan and provide guidance through the entire underwriting experience. Some of the most popular and common mortgage products include a fixed rate mortgage, adjustable rate mortgage, FHA loan and VA loan. All of these options have a list of requirements that need to be met in order to qualify as well as various criteria that can make getting a loan more difficult or easier depending on your personal financial situation. There are also loan product types available to incentivize buyers to enter the market even if they can’t afford a 20% down payment or if they are struggling with a low credit score.
Interest rates have a significant impact on our entire economy by influencing stock and bond interest rates, consumer and business spending, inflation and recessions. Understanding the relationship between interest rates and the economy is important so that you can get a good idea of the big picture and it will ultimately help you make more informed investment decisions. Understanding how interest rates are influenced and how they can impact your buying power is also important because it will empower you to make more informed and intelligent decisions when applying for a mortgage or other line of credit.
If you are interested in learning more about interest rates on mortgages, please don’t hesitate to connect with us so we can refer you to a wonderful lender who can assist you with all of your needs and answer any questions that you may have. We would also be happy to share information on the current state of the market, how interest rates are currently affecting home prices and show you some of our featured properties currently listed for sale. We look forward to hearing from you soon and helping you make your real estate dreams a reality!
Real Estate Glossary