The Property Line: What’s With the Surge in Mortgage Rates?
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The Federal Reserve gave us low mortgage rates, and the Fed is taking them away.
Mortgage rates have risen about a percentage point since just before Christmas, and at this writing, are around 4% for the 30-year loan. They're expected to trend above 2021 rates all year, costing home buyers and equity borrowers money. Here's how and why a dozen policymakers inside the Fed are causing this financial pain, and how you can respond.
2020: The Fed sends rates plunging
The recent increase in mortgage rates is grounded in actions the central bank's 12-member Federal Open Market Committee took in the pandemic's early days, when millions of workers were laid off and the financial system was under strain.
In March 2020, the committee abruptly intervened to soften the COVID-19 recession. The Fed's urgent goal was to stabilize financial markets, explains Michael Fratantoni, chief economist for the Mortgage Bankers Association. But the central bank also wanted to stimulate the economy to keep the recession short.
The Fed energized the economy by decreasing interest rates for both short-term and long-term loans, making it cheaper to borrow and spend.
The short-term prime rate plunged from 4.75% to 3.25%, after the central bank slashed the federal funds rate to the bone. The rates on most credit cards and home equity lines of credit are linked to the prime rate, so customers saw their rates fall 1.5 percentage points.
On the long-term end, the average rate on the 30-year fixed-rate mortgage dropped from 3.29% in early March to 2.65% at the beginning of 2021, according to Freddie Mac. Home buyers and refinancers capitalized on the historically low mortgage rates.
But the rock-bottom federal funds rate didn't drive mortgage rates so low; the central bank used another mechanism for that.
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How the Fed cut mortgage rates
The central bank doesn't actually control mortgage rates, which are set by market forces. That's normally the case, at least.
But when the pandemic hit, the Fed massively intervened in the home loan market. It bought more than $1 trillion in mortgage-backed securities in 2020 and 2021. It bid up the prices of these securities, flushing mortgage rates to record lows.
The Fed's trillion-dollar buying spree reduced the supply of mortgage-backed securities in the broader market, Selma Hepp, deputy chief economist for CoreLogic, said in an email. The Fed hoarded mortgage bonds, creating scarcity. Private investors "then bid up the prices of the remaining supply, lowering their yield and keeping mortgage rates low," Hepp said.
The Federal Reserve engineered this easy-money policy to save borrowers money. But low interest rates couldn't last forever. Like supply-chain issues, low rates contributed to inflation, spelling their doom.
2022: The Fed pushes mortgage rates higher
Prices have risen for everything from gasoline to eggs to houses. The central bank said in November that high inflation is one sign that the economy has recovered enough to justify reducing those monthly purchases of mortgage bonds and government debt.
Picture each $1 billion in mortgage-bond stimulus as the pick-me-up you get from a cup of coffee. The Fed pledged to pour 40 cups in October, 35 cups in November and 30 cups in December. Mortgage rates edged up slightly, as the bond market adjusted to the gradual and predictable stimulus withdrawal.
Then, in mid-December, the Fed said it would cut back more rapidly: to 20 cups in January instead of 25, and 10 cups in February instead of 20. It confirmed in January that it would go to zero in March.
This news swiftly brought on a caffeine headache: Rates jumped half a percentage point from December to January. Then, they zoomed another half point by mid-February. Rates went up much faster than experts had predicted in November. Whether they will plateau, ease back down or continue climbing once the initial headache passes is yet to be seen.
How to cope with higher mortgage rates
As interest rates push higher, borrowers' costs will rise. Among home buyers' options:
Buy sooner rather than later, before rates rise even higher. This is easy to suggest and hard to do because potential buyers outnumber sellers, bidding wars are commonplace and buyers can't control how long it will take to make a successful offer.
Budget for a higher monthly payment. The principal and interest on $425,000 is $2,029 a month if you get a 30-year mortgage at 4%. But if the rate is 4.5% when you find a house, the principal and interest amount to $2,153 a month, or $124 more.
Shop for lower-priced houses. Let's say you can afford $1,500 in principal and interest every month on a 30-year loan. At an interest rate of 4%, you could afford to borrow around $314,200. At a 4.5% rate, you could borrow about $296,000, or $18,200 less.
People will still buy homes because demand is so high, says Tom Gillen, senior vice president of capital markets for Churchill Mortgage.
"Hey, 4% interest rates, even a 5% interest rate: Guys, we're still selling houses," he says. "The biggest issue that we’ve got in the real estate industry today has nothing to do with increasing interest rates, it has to do with a lack of supply.”
Heads-up that HELOC rates will rise
Central bankers have targeted short-term interest rates, too: In March, they almost certainly will raise the federal funds rate. Traders in fed funds futures are betting that the central bank will lift the federal funds rate by at least 1.75 percentage points in 2022, according to the futures market's CME FedWatch Tool.
The prime rate will rise in lockstep with the federal funds rate, meaning that borrowers will pay higher interest rates on their home equity line of credit balances.
Minimum monthly payments on HELOCs will climb every time the Fed raises the federal funds rate. Let's say you have a $20,000 balance on your HELOC that began the year with an interest rate of 4.5%, and it rises to 6% at the end of the year. An interest-only monthly payment would rise from $75 to $100.
A $25 increase isn't much, but that’s $300 a year that has to come out of the budget somehow. Maybe you don't go to Waffle House as often, or you make one less trip to the movies each month. Multiply small-scale belt-tightening by millions of consumers, and you end up with a measurable slowdown in economic activity and lower inflation. That's the Fed's goal — after giving us higher inflation, to take it away.