How the Fed Funds Rate Affects Home Buyers and Sellers

What the future holds for interest rates and how interest rates influence the real estate market

The actions of the Federal Reserve often lie outside the attention of mainstream consumers, but lately, this central bank has dominated the news politically and economically. Since the Fed’s decisions can be very confusing to follow and comprehend, many home buyers and sellers are left wondering how the Federal Reserve affects mortgage rates and related real estate transactions.

In short, the Fed sets a target interest rate for banks to lend money to one another overnight, which often affects how much they charge to lend to consumers. However, because the Fed’s focus is on short-term lending rates, long-term loans like mortgages don’t always move in unison.

The two rates are still correlated. When the Fed made the decision at the end of July to cut rates, banks’ borrowing rate went down, which tends to coincide with mortgage rates falling too. Conversely, if the Fed were to start raising rates again, mortgage rates would likely increase.

How does the Federal Reserve influence interest rates in general?

The Fed has a few different ways to affect interest rates, but when you see headlines about rate cuts or rate hikes, that generally refers to the federal funds rate.

Since banks are required to keep a certain amount of cash on hand depending on factors such as their size, they often need to borrow from one another on a short-term basis to meet that requirement. As such, the Fed sets a target rate, also known as the fed funds rate, for this borrowing by buying and selling government bonds from financial markets. In doing so, they can increase or decrease the money supply in the financial system. More supply through buying bonds means that interest rates go down, as banks have more cash to lend and vice versa.

The Fed takes these actions to try to manage inflation to a target of 2% annually. A larger money supply with lower interest rates increases inflation, and vice versa. Having some level of inflation helps encourage people to spend and lend money, as doing nothing with cash will cause it to lose value over time. Too much inflation, however, can erode people’s ability to make purchases and cause an economic slowdown. For example, if you were saving up for a $500,000 house but inflation quickly caused the house price to climb to $1 million, you wouldn’t be able to make that purchase at all.

How does the fed funds rate influence the real estate market?

With the fed funds rate in place, banks can then set interest rates for their customers. These rates are higher than what banks charge one another for overnight lending, as they want to make a profit from customers. For example, banks generally set the prime rate, a general term for what they charge their best customers for a loan, at three percentage points above the fed funds rate. That means that with the Fed lowering the fed funds rate at 2-2.25% in July, the prime rate sits at 5.25%. Prime rates can directly affect the real estate market, such as with home equity lines of credit (HELOC) often being set based on the prime rate plus an additional percentage. So when the prime rate moves, so too do HELOC rates.

Mortgage rates tend to be less directly affected, as these long-term loans have several additional factors attached to them. Aside from the fed funds rate and prime rate, banks also have to consider issues ranging from local real estate market conditions to the interest rate on long-term government bonds.

Overall, the fed funds rate tends to more closely track short-term interest rates than long-term ones, as the Federal Reserve Bank of St. Louis notes. A correlation between the fed funds rate and mortgages does exist, which may be due in part to long-term rates being set in relation to the short-term ones the Fed directly influences. It is also possible that banks issuing mortgages adjust rates based on their own projections, such as by lowering mortgage rates in a perceived slowing economy, before the Fed acts to lower the fed funds rate.

Chart based on this data: https://fred.stlouisfed.org/series/FEDFUNDS#0

What has the Fed done lately with interest rates?

Amidst the 2007-2008 financial crisis, the Federal Reserve aggressively cut banks’ overnight lending rates essentially to zero. Rates stayed there until the end of 2015 when the central bank lifted rates a quarter of a percentage point, which is partly why the interest rate on your savings accounts have likely been low to nonexistent over the past decade, while mortgage rates have also fallen substantially compared with pre-crisis levels. Based on data from the Federal Reserve Bank of St. Louis, interest rates for 30-year fixed mortgages climbed to over 6.5% in mid-2008, but fell to under 3.5% by 2012, and have stayed below 5% since.

From 2015-2018, the Fed slowly raised rates up to a target of 2.25-2.5%, still significantly down from the pre-crisis high of 5.25%. Yet while at the beginning of 2019 the market looked like rates would continue to rise, conditions have changed. The Fed cut rates by a quarter of a percentage point at the end of July this year, even though the economy continues to expand, because of signs of a potential global slowdown and greater uncertainty due to issues such as trade wars. By lowering rates now before an event like a recession occurs, the Fed is being somewhat proactive and trying to support a healthy economy and inflation level.

During much of this period of rising rates from the Fed, interest rates for 30-year fixed mortgages also generally went up, rising from below 3.5% in late 2016 to just under 5% toward the end of 2018. Since then, however, with less certainty of economic strength, mortgage rates quickly tumbled back down to 3.6% as of August 2019.

The outlook remains uncertain as to what the Fed will do next. Fed members were mixed in July regarding whether or not to cut rates, with some members wanting a larger cut and some not wanting a cut at all. Minutes from the meeting indicate the central bank is not on a clear path toward more cuts, but the Fed will continue to monitor economic conditions and act accordingly.

Wall Street economists, however, expect that the Fed will continue to cut rates a few more times this year and next, as reported by CNBC. Projections differ regarding how aggressively the Fed will cut rates, but the general consensus shows a downward trajectory on rates over the next couple years.

The health of the economy will be key to how the Fed actually moves on interest rates. If a recession occurs, as most economists predict will happen by 2021, according to a National Association for Business Economics survey, then lower interest rates are almost certainly on the horizon. Meanwhile, the Fed will try to stave off a recession through its monetary policy, which could still mean lower rates over the next couple years. In order for rates to climb back up, the economy would have to get on more stable footing with clearer signs of upward growth over the next few years.

What do potential rate cuts mean for the health of the real estate market?

Given the correlation between the fed funds rate and mortgage rates, the expected Fed rate cuts likely mean that mortgage rates will also fall, or at least remain low. Having low rates can spur more real estate transactions as buyers may be able to more easily afford the interest paid on a mortgage.

However, as a Redfin analysis finds, the increase in demand associated with falling mortgage rates then pushes house prices up, so buyers’ savings may be somewhat offset.

Complicating the situation further, even though sellers would ordinarily benefit from higher prices, demand could quickly dry up if mortgage rates fall because of a recession. Altogether, the best-case scenario for the real estate market may be for rates to stay neutral or fall slightly, but for the economy to continue to hum along and inflation to hit 2%, as the Fed is trying to achieve.

The next Fed meeting will take place September 17-18, after which it should be clearer whether the Fed is on a path of more rate cuts or if the July cut looks more like an isolated event. Those considering buying in this environment should weigh lower mortgage rates against the conflicting possibilities of either increased demand causing housing prices to climb or for a recession to cause mortgages to go underwater. Sellers should also weigh whether market conditions will likely lead to strong demand from buyers or if a faltering economy means they should wait until conditions improve to maximize their selling price.

While trying to time the market may be tempting, many will find other circumstances to dictate the timing of future home purchases and sales. Companies that charge low fixed fees, like Home Bay, can serve as a hedge in times of economic uncertainty by putting more of the final sales revenue back in the pocket of home sellers. Whether the economy charges forward or takes a few steps back, keeping more profit will translate to greater buying power on the next home.

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