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Interest Rates' Impact on The Housing Market

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Most people need a mortgage to buy a home, and this means borrowing money from a lender. The lender will always charge interest on top of the principal amount used to buy the home. The interest rate depends on a number of factors, including those related to monetary policy and the health of the economy, as well as those related to your personal finances and credit history. Learn more about how these rates affect the housing market and your bottom line.

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Yellow notepad with pen svg icon Lesson Notes:
  • Interest rates are always changing based on the latest monetary policy and the health of the economy.
  • These rates will affect how much you pay in interest when using a mortgage to buy a home.
  • You can use the latest economic forecast to get a sense of where interest rates might be heading.

How do Mortgage Rates Affect Home Buying

There are two types of mortgages: fixed and adjustable-rate mortgages (ARMs). Fixed mortgages have a fixed interest rate that won’t change over time. Adjustable-rate mortgages have interest rates that can increase or decrease over time. If you’re in the market for a home, you’ll need to choose between these two types of mortgages based on how interest rates will change over time.

For example, if you believe mortgage interest rates to go up, you might want to buy a home or refinance your mortgage sooner rather than later to avoid potentially higher interest rates. You may also want to go with a fixed-rate mortgage over an adjustable-rate mortgage to lock in a predictable rate before the average rate increases.

On the other hand, if you believe interest rates to go down, you might want to hold off on buying a home or refinancing your mortgage until rates are lower. You may also want to go with an adjustable rate over a fixed-rate mortgage, so you can take advantage of the lower interest rate and then refinance your mortgage when fixed rates go down.

How Interest Rates Change Over Time

Rates will periodically adjust based on the health of the economy, inflation rates and other factors.

As a consumer, you can look for signs that the economy is growing or shrinking to get an idea if interest rates on mortgages may change in the future.

The Federal Reserve will raise interest rates (federal funds rate) during periods of high inflation, which makes it more difficult and expensive to borrow money. This slows down the economy by limiting the amount of money in the market, which then reduces demand and slows the rate of inflation.

In contrast, the Federal Reserve will lower interest rates during periods of economic crisis, such as during a depression or recession. This makes it easier for businesses and consumers to borrow money, which stimulates economic growth and decreases unemployment. However, this can lead to inflation over time if interest rates aren’t normalized.

While mortgage rates are not set by the Federal Reserve or directly tied to the federal funds rate, they are influenced by them. Mortgage interest rates usually move in the same direction as the federal funds rate, which means that if the Federal Reserve raises interest rates, we are likely to see mortgage rates move higher as well.

Considerations When Choosing Between a Fixed versus Adjustable-Rate Mortgage

You’ll need to keep these considerations in mind when trying to find the best mortgage rates and choosing between a fixed or adjustable-rate mortgage. The lower your interest rate, the greater purchasing power you have and the faster you can pay off your home.

Fixed-Rate Mortgage

The 30-year fixed mortgage remains the benchmark for most of the housing market, even though most borrowers refinance their mortgages before the end of the loan. As the name suggests, fixed-rate mortgages have a set interest rate over the life of the loan. This means that your principal and interest payment should remain consistent over time and is easier to budget for.

These types of home loans may be beneficial if you plan to stay in your house for five years or more or if interest rates are at historical lows like we saw during the COVID-19 pandemic.

Adjustable-Rate Mortgage

If you go with an adjustable-rate mortgage, remember that your monthly interest rate will change over time. ARMs typically have an initial rate lock period where the interest rate stays the same. After the initial period, the interest rates are adjusted at regular intervals.

For example, a 5/5 ARM has an initial rate lock period of five years and is adjusted every five years after that. ARMs typically have a rate increase cap per adjustment period and an overall cap for the life of the loan.

These types of mortgages may be beneficial during periods where interest rates are increasing so you can have more purchasing power up-front with a lower interest rate during the rate lock period. You may also want to consider these loans if you plan to sell the home in less than five years.

Regardless of if you choose a fixed-rate or adjustable-rate mortgage, if interest rates become more favorable and drop lower than your first mortgage, you can refinance to lock in a lower interest rate and reduce your monthly payments. Remember that refinancing may come with origination fees and other costs.

Outside of economic conditions, the interest rate of the home loan will also be affected by factors like the size of your down payment, DTI ratio and credit score. When you’re applying for a mortgage, try to improve these factors to help you lock in a lower interest rate.

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