Forex Articles

Few economic events garner as much attention as the Federal Reserve's policy meetings. Everyone wants to know if and when the Fed is going to finally raise interest rates – after an unprecedented zero-bound regime – and what the potential fallout might be. The housing market is particularly interesting, partially because home sales are so dependent on interest levels and partially because it was the collapse of the housing market that spurred the last Great Recession.

Directly or indirectly, an interest rate hike affects anyone with a home mortgage. This is most obvious for those who have adjustable-rate mortgages (ARMs), since their monthly interest payments will increase immediately.

The federal funds rate has been at or near 0 since 2008, translating to record-low mortgage rates in the United States. Between mid-2014 and mid-2015, the average 30-year fixed loan settled for less than 4%. Home buyers have never seen credit this cheap for this long, and many current homeowners were able to refinance to attractive new rates.

Rising interest rates would compromise the low-rate mortgage market, which affects buyers and sellers, although in different ways. As a general rule, buyers can afford to buy in a more expensive range of homes when interest rates are low, because their monthly interest payments are reduced. As rates rise, buyers are pushed out of expensive markets, at least initially; if too many buyers are priced out of a market, ask prices are likely to fall.

Modern central banks, including the Federal Reserve, affect interest rates by changing the amount of money circulating in the economy. This normally takes place through the purchase or sale of U.S. Treasurys, which form the baseline rate in capital markets.

Suppose the Fed wants to raise interest rates in the economy. With the help of the Treasury Department, the Federal Reserve sells Treasurys on the market. Investors (mostly banks, governments and other large institutions) buy those Treasurys with cash, and the cash just sits on the Fed's balance sheet.

Cash on the Fed balance sheet is no longer circulating in the economy, thereby effectively reducing the money supply. More Treasurys are on the market competing for sellers, and there is less cash going around to bid up the price of these Treasurys. Both factors suppress Treasury prices, which increases their rates of return. (Remember that Treasurys and other bonds have higher yields at lower prices, because the difference between the purchase price and the redemption price is larger.)

Treasury bonds represent the safest way to earn a return on the market, so all other products – including mortgages – have to add extra return to entice investors and lenders away from Treasurys. When the returns on Treasurys rise, so too do other rates in the economy.

Interest rate hikes make borrowing money more expensive, and homebuyers use mortgage loans for virtually all home purchases. Mortgages tend to have a multidecade outlook, so lenders are likely to begin raising rates before the Fed does; after all, lenders know a rate hike is coming eventually.

Even half of a percentage point makes a big difference over time. Suppose a buyer takes out a $250,000 loan over 30 years at 3.92% (roughly the average market rate in September 2015); his monthly payment should come out to around $1,182, and the total cost of his mortgage is expected to be around $425,000.

Change the interest rate to 4.42%, however, and the monthly payment amount moves to $1,255. This may not seem like much, but the total cost of the mortgage now exceeds $451,000 – a $26,000 increase.

It's clear to see that a Fed rate hike will make financing more expensive, but it's less clear what the impact will be on home prices.

There isn't a strict historical correlation between home prices and interest rate hikes. A far better correlation exists between home prices and gross domestic product (GDP) growth; demand for new homes tends to grow when the economy is humming.

A rising interest rate can break both ways. Many prognosticators are concerned that a rising interest rate will shake an unsteady economy, which should depress demand for home purchases. Combine this with tougher financing terms, and it's easy to guess that home prices should decline.

However, since at least the mid-1980s, a rising interest rate has normally coincided with a healthier economy. This means more buyers on the market, more homes being built and higher prices.

Aspiring homebuyers shouldn't overthink with regards to Fed policy. Even if the rates go up modestly – most expect a quarter-point increase in late 2015 or early 2016 – borrowing costs will be near historic lows. Of course, there are many other important considerations, such as a buyer's income or whether the home is in a good neighborhood. In the end, a small rate increase should only have a modest influence on buying decisions.

The average 30-year fixed rate mortgage in August 2015 was 3.91%, according to Freddie Mac. This is above the record lows in late 2012 of 3.35%, but still far below historic levels. Consider that the average rate was 4.69% in 2010, 5.87% in 2005, 8.05% in 2000 and 13.74% in 1980.

If a homebuyer is looking in an expensive, booming real estate market, such as San Diego, Denver, Dallas or San Francisco, there may be an impetus to lock in a lower rate before the Fed targets a higher interest rate.

Rising rates make a bigger difference in the long run (25 and 30 years out), but they have only a modest monthly impact. If an aspiring buyer is unlikely to stay in a home for a long time, interest rates take on a lot less significance.

Rising interest rates decrease the likelihood of another housing bubble burst, such as the one in 2007. It's safer in the long run for homeowners to have a steady, rising rate environment. It's difficult to predict the economic impact of a Fed hike, but history shows that asset bubbles form when rates are low, and not the other way around.