The housing market is closely tied to interest rates. When interest rates rise or fall, there are ripple effects throughout the housing industry that impact home prices, affordability, and home sales. Understanding how interest rates impact the housing market can help buyers, sellers, investors, and industry professionals make informed decisions.

Understanding the Impact of Interest Rates on the Housing Market

How Interest Rates Affect Mortgages

For most home buyers, the cost of a mortgage is the biggest factor in affordability. Mortgage rates directly influence monthly payments and the total cost of homeownership. When interest rates rise, the cost of borrowing money and servicing debt increases. This gets passed along to home buyers in the form of higher mortgage rates.

Even small fluctuations in interest rates can make a big difference in affordability over the lifetime of a loan. For example, on a $300,000 fixed-rate 30-year mortgage, a rate increase from 3% to 4% would mean the monthly payment jumps by $190 and the total interest paid over the life of the loan increases by nearly $54,000.

This affects buying power. When rates rise, buyers may no longer qualify for a loan of the same amount because the monthly payments would be too high relative to their income. Or, they may have to reduce their price range when shopping for homes so the monthly payment on a lower mortgage balance fits within their budget.

The dynamic works the other way too. When rates fall, buying power increases as lower monthly payments allow borrowers to qualify for higher loan amounts. This expands the pool of eligible home buyers and enables more people to enter the market.

Impact on Refinancing

Refinancing an existing mortgage can enable homeowners to secure a lower interest rate, reduce monthly payments, tap home equity, or change loan terms. But refinancing only makes sense if the homeowner can get a rate that is significantly lower than their existing rate.

When rates rise, fewer people qualify to refinance because their current loan rate is lower than what is available. Refinancing volume dries up. Of course, when rates fall substantially, a wave of refinancing occurs as homeowners rush to lock in lower rates and reduce housing costs.

The ability to refinance can affect people’s willingness and ability to purchase a home. Low rates open up opportunities to refinance affordably after buying, which can make buyers more confident about financing home purchases.

Home Prices and Interest Rates

Interest rates impact home values. When rates decline, the monthly costs of homeownership decrease. This increases demand among buyers as more people can afford higher-priced homes. Higher demand coupled with limited housing inventory places upward pressure on home values.

In a hot housing market, bidding wars may erupt, homes may sell above the asking price, and prices will appreciate rapidly. On the other hand, when rates spike, the opposite occurs - demand drops, inventory accumulates, bidding wars cease, and price appreciation cools. Home prices are very sensitive to changes in mortgage rates.

However, interest rates are just one factor influencing prices. Other factors like employment trends, inventory levels, demographics, income growth, and access to credit also play a role. So while rates impact prices, they do not solely dictate market conditions.

The Housing Market Cycle

Interest rates often align with cycles in the housing market. During strong economic times, employment and incomes rise. The Federal Reserve will increase the Fed Funds rate to keep inflation in check. Mortgage rates follow suit.

Despite higher borrowing costs, demand remains high due to robust economic fundamentals. Home prices appreciate. Eventually, rising rates temper demand, prices soften, and the housing market slow.

In downturns, the Federal Reserve lowers rates to spur economic growth. Mortgage rates fall in tandem. Lower rates boost home buying and refinancing, fueling demand even amid slow economic conditions. Home prices may rebound before the broader economy fully recovers.

Being aware of where we are in the current housing cycle, and anticipating trend changes, can help buyers and sellers maximize opportunities. Interest rates signal the timing for changes in demand and pricing.

The Federal Reserve and Mortgage Rates

Mortgage interest rates are tracked closely with the Federal Reserve's Federal Funds rate. This is the rate banks charge each other for short-term borrowing. It serves as the basis for all other interest rates.

While the Federal Reserve does not directly control long-term mortgage rates, its decisions influence them. When the Federal Reserve raises or lowers the Fed Funds rate, mortgage rates tend to follow. However, they do not move in perfect lockstep.

Sometimes mortgage rates change direction even if the Fed makes no changes. Many factors affect mortgage rates, including inflation, employment trends, GDP growth, currency values, and changes to the overall bond market. But the Fed still has an outsized impact.

Its dual mandate focuses on maximizing employment while keeping inflation low and stable. If the economy runs too hot, the Fed raises rates to cool it off, and control inflation. If growth is sluggish, the Fed lowers rates to boost activity. Both actions impact mortgage rates. Understanding the Fed's rationale for rate changes helps predict mortgage rate moves.

The Takeaway

Interest rates have an outsized influence on the housing sector. They drive affordability and borrowing capacity, impacting who can buy homes and how much they'll pay. Rates also dictate refinancing volume and influence home price appreciation.

While many factors affect the housing market, interest rates are the primary mechanism for controlling economic growth and inflation. So mortgage rates tend to rise in healthy economies when purchasing power is strong, moderating demand and prices. And rates fall during downturns or recessions to stimulate growth.

Watching the Fed and paying attention to rate trends provides key insight into where the housing market is headed next. Understanding interest rate dynamics allows industry professionals and consumers to make informed decisions and time their transactions appropriately. With rates integral to housing and economic cycles, they are among the most important bellwethers to monitor.