For many years, Americans enjoyed the bounty of artificially low interest rates set by our central bank, the Federal Reserve. Now, the Fed has announced plans to increase interest rates gradually over the next several months and years. Already, interest rates are climbing higher – and they’re only going to grow higher from here.
So, what does this mean for the real estate world?
The Basics of Interest Rates
Let’s start by explaining the basics of central bank interest rates. The Federal Reserve, like most central banks, engages in many active practices to control and regulate the economy. One of the most important responsibilities of the Fed is manipulating the money supply to achieve better economic outcomes; they do this by lending money to major banks in the United States at a set interest rate. Banks can then lend this money to their customers, charging a higher interest rate and making money in the process.
It goes something like this: The Fed sets the Fed Funds Rate to 2 percent, so banks can borrow money at 2 percent interest. Banks then set the interest rate for a 30-year, fixed mortgage to 4 percent interest, so they can make a profit.
The Fed can lower interest rates to increase the money supply, thus stimulating the economy and promoting borrowing (and other types of economic activity). The Fed can also increase interest rates to limit the money supply, preventing inflation from getting out of control and reducing borrowing activities. The Fed attempts to strike a careful economic balance, promoting economic growth and development without hurting the economy.
Recent moves to hike interest rates come as a response to price inflation and are intended to rein in irrational economic decision making.
The High-Level Effects of Rising Interest Rates
So, what do rising interest rates mean for real estate investors?
There are several high-level effects to keep in mind:
- Less purchasing power. Higher interest rates usually mean less purchasing power for the average homeowner. Most homebuyers and real estate investors borrow money to make their purchases, and higher interest rates influence how much they can borrow. With a higher interest rate, your monthly payments are going to increase, so the total amount you can borrow while staying within budget is reduced.
- Less favorable conditions for borrowers. Overall, higher interest rates mean less favorable conditions for borrowers. Remember, you’ll be paying interest on the principal you borrow for many years – sometimes 30 years or more. In addition to a higher monthly payment for the same amount borrowed, you’ll end up paying more money in interest over the duration of your loan. Even if your mortgage rate only goes up by 1 percent, that could add up to thousands of dollars every year.
- Variable interest rate changes. Variable interest rate mortgages aren’t nearly as popular as they used to be, but if you happen to have one, you can expect your interest rate to rise. An ideal time to refinance would have been when interest rates were lower, but refinancing to a fixed interest rate could still be advantageous to you.
- Reduced inflation. Increased interest rates may have the ability to reduce the effects of inflation. Price inflation typically occurs when there’s a massive increase in the money supply, such as when Federal Reserve interest rates are artificially low. Since we’ve had very low interest rates for most of this century, we have to do catch-up work to reduce the effects of inflation. This can be a good thing for real estate investors, since it means property prices won’t spiral out of control; but this can also be a bad thing if you have lots of good debt, since the value of debt decreases with inflation.
Ultimately, this typically results in:
- Slowing demand. The number of home purchases skyrocketed over the last several years, but this momentum is finally beginning to slow. With higher interest rates and less favorable conditions for buyers, fewer people are interested in buying a house.
- Lower property prices. Thanks to slowing demand and less purchasing power, we will likely see lower property prices overall. Accordingly, we might be setting ourselves up for a great real estate buying opportunity, with low prices and less competition.
- Lower rent prices. If you own rental properties, or if you plan to own them in the future, you might experience the detriment of lower rent prices. Cheaper houses and available mortgages could push people out of renting altogether.
As you can see, there are both opportunities and threats to most real estate investors.
Important Caveats About Interest Rates
There are some important caveats you should understand as well:
- Interest rates are only one variable. As you probably understand, real estate decisions are complex; you need to consider many different economic variables before pulling the trigger. Interest rates are merely one variable in a complicated equation. You shouldn’t make sweeping changes to your real estate portfolio or your approach to investing based on only one variable.
- Interest rates are typically a byproduct of broader economic trends. The Federal Reserve increases interest rates as a response to broader economic conditions. Interest rates are typically lowered in response to catastrophic economic conditions, like the onset of a major recession. Climbing interest rates can therefore be perceived as a sign of faith in the future of the economy.
- Different areas will respond differently. Each area is unique. Rising interest rates may result in lower prices in one city, but prices in other cities may continue going up if they have sufficiently high demand.
- Interest rates fluctuate. Finally, remember that the Federal Reserve adjusts interest rates frequently. A temporary increase in interest rates will only have a temporary influence on the real estate world.
Are you interested in purchasing a house for yourself, or a rental property to add to your portfolio? Do you need professional guidance to make a more educated, more fiscally responsible choice in these uncertain economic times? Green Residential is here to help. Contact us for a free consultation today!