Why the Fed wants home buyers to face higher mortgage rates

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The Federal Reserve raised a short-term interest rate last week, making it more expensive to borrow money to buy a house or repair it.

All in the name of slowing inflation.

The central bank on Wednesday raised the federal funds rate by 0.5%, or half a percentage point. The Fed had not raised the federal funds rate by half a percentage point in a single meeting since 2000.

The 0.5% increase is seen as a “hawkish” or aggressively anti-inflationary measure. Prominent Fed officials had hinted for weeks that they would be making a bigger-than-usual rate hike, and mortgage rates had already risen sharply in anticipation of that, climbing about three-quarters of a point. percentage from mid-March to the end of April.

“The rhetoric that’s been going on over the past few weeks has all been about a much more hawkish stance, and that’s really where this interest rate hike has happened,” said Selma Hepp, deputy chief economist for CoreLogic. , a provider of real estate information and analysis.

The effect of the Fed on mortgage and stock rates

The Fed increase will cause other interest rates to rise, some directly and some indirectly.

A higher federal funds rate will directly increase the rates charged on adjustable rate home equity lines of credit. They will increase by 0.5% in a billing cycle or two. These loans, also called HELOCs, are often used to pay for home renovations.

The Fed also has an indirect impact on mortgage rates, which rose steadily in March and April because the markets knew this increase was coming. Mortgage rates should continue to climb, as the Fed has only raised the fed funds rate twice this cycle and markets are expecting several more hikes.

Lawrence Yun, chief economist of the National Association of Realtors, noted that the 30-year mortgage rate has risen much more this year than the federal funds rate.

“This implies that the market is already valuing around eight to 10 series of [Fed] rates are increasing this year,” Yun said. “If inflation increases, the Fed will have to be even more aggressive, which will push mortgage rates even higher. »

How expensive mortgages reduce inflation

Typically, the Fed raises the federal funds rate 0.25% at a time. But no one would call today’s economy typical. The consumer price index, a gauge of inflation, hit 8.5% in March, its highest level in more than 40 years. The Fed is showing it’s serious about inflation by raising the federal funds rate to twice the usual increase.

“We are really committed to using our tools to get inflation back to 2%,” Fed Chairman Jerome Powell said last month during a roundtable presented by the International Monetary Fund.

You might consider raising the costs of buying a home as a weird way to control runaway price increases. But higher mortgage rates could put a damper on the rapid rise in home prices, as many homebuyers are buying with a monthly payment in mind. As mortgages become more expensive, buyers may be forced to shop around for cheaper homes, which could slow the pace of home price increases and, therefore, dampen inflation.

Consider the hypothetical example of a person who can afford $1,700 a month for mortgage principal and interest and started house shopping in February. At the time, the 30-year fixed rate mortgage averaged around 4%. Let’s say our house hunter finally made a successful offer at the end of April, when the 30-year mortgage rose to around 5.25%. Here’s how the rate increase affects how much this buyer can afford to borrow:

At 4%, the buyer can afford to borrow $356,100. At 5.25%, the buyer can afford a mortgage of $307,900, a loss of borrowing capacity of $48,200.

HELOC borrowers and home sellers are not spared

Higher interest rates affect more than homebuyers. They are also changing the calculations for HELOC borrowers and home sellers.

Interest rates on variable rate HELOCs are tied to the prime rate, which moves in parallel with the federal funds rate. Homeowners with balances on their HELOCs may see their interest charges increase as the interest rate increases. For every $50,000 owed on a HELOC, a 0.5% increase in the interest rate increases the monthly interest by $20.83.

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