How Interest Rate Increases Impact Homebuyers
Homebuyers or owners especially could benefit from developing a greater understanding about the Fed and how it influences the U.S. markets.
Anyone who pays attention to financial news has likely been seeing many headlines recently speculating about what the Federal Reserve is up to. Most of the news speaks in broad economic terms that may seem confusing or unrelated to the life of the average consumer. In fact, news and predictions on what the Fed is planning have wide-reaching implications for just about everyone, although they appear subtle. Homebuyers or owners especially could benefit from developing a greater understanding about the Fed and how it influences the U.S. markets.
What the Fed does
The Federal Reserve is the central bank of the United States. As the Federal Reserve Bank of Atlanta explains on its website, this independent entity gives the nation control over how money is spent and saved both within its own borders and throughout the world. At the same time, the Fed loans money to private banks and other institutions. The return it expects in exchange for this service is the federal funds rate, which is the "interest rate" that everyone talks about when discussing the Fed's actions.
"The Fed's actions affect more than just banks and businesses."
As general trends in the economy shift over time, the federal funds rate shifts alongside it to keep the U.S. economy in balance. In times of high growth, too much lending from the Fed can lead to inflation, which can cause the price of goods and services to rise. In this instance, the Fed will usually raise interest rates to ensure the value of a dollar does not decline too much in an inflationary spiral.
On the other hand, some inflation is still desired. If the value of money stayed constant, people and businesses would have less incentive to trade it for goods and services. That's why when the value of a dollar drops too much, the Fed will lower the federal funds rate to jolt the economy back to life, stimulating spending and further growth.
Where we stand now
This basic theory behind interest rates has kept the economy relatively stable since the Great Depression. That is, until 2007, when a number of risky investments made by several large banks went sour, causing a serious devaluation of the dollar and triggering the recession, a period of negative economic growth. In response, the Fed gradually lowered interest rates to almost nothing, allowing banks to borrow money very cheaply. In theory, this was supposed to beef up the economy in short order.
But even in 2016, nearly a decade removed from the financial crisis, the Fed is still hesitant on raising rates again. As Bloomberg noted, the central bank did increase the rate slightly in December 2015, the first time in seven years. However, general economic growth has not met the Fed's targets, keeping the rate at its lowest point ever.
What it means for homeowners and buyers
Since the Fed loans money to banks with interest, the rate they charge ends up influencing what banks then charge consumers for their own loans. Therefore, an increase in the Fed rate, expected or otherwise, could lead to an increase in the cost of a mortgage. As Nerdwallet explained, higher rates may affect first-time buyers more than those with savings established.
For those who already own a home, higher interest rates still may have an effect. Of course, refinancing may no longer be advantageous if the current loan was acquired at a lower, fixed rate. Any current homeowners looking to move into another home may also find themselves having to trade up to a more expensive mortgage. However, borrowers with an adjustable-rate loan may want to look into refinancing as rates begin to rise. Still, the various fees associated with this need to be weighed against potential long-term savings.
Understanding the Fed is tough even for established economists. Even so, it can prove beneficial for the average homeowner or buyer to make sense of it all.