What the Fed’s December rate hike means for home buyers and sellers

This article was originally posted on Bankrate.com.

The Federal Reserve raised interest rates for the seventh consecutive time this year. This time, though, the hike is smaller: Fed Chair Jerome Powell announced a half-point hike in the federal funds rate on Dec. 14, which is down from three-quarter-point hikes at previous meetings. However, the last time it raised rates that much in a single year was in the 1980s.

In an effort to curb raging inflation, the Fed raised interest rates by a quarter point in March 2022, then by a half point in May. It raised them even more in June, by three-quarters of a percentage point — which was, at the time, the Fed’s biggest rate hike since 1994 — and continued to do the same in July, September and November.

The hikes are designed to cool an economy that was on fire after the rebound from the 2020 coronavirus recession. That dramatic recovery has included a red-hot housing market characterized by record home prices and microscopic levels of inventory.

However, since late summer the housing market has shown signs of a cooling down, with appreciation slowing nationwide and prices even declining in many markets. And home prices are driven not just by interest rates but by a complicated mix of factors, so it’s hard to predict exactly how the Fed’s efforts will affect the housing market.

“The real estate recession is here,” says Marty Green, principal at law firm Polunsky Beitel Green. “The big question now is how quickly it spreads to the rest of the economy.”

Higher rates are a challenge for both home buyers, who face higher monthly payments, and sellers, who experience lower demand and/or lower offers for their homes.

“The cumulative effect of this sharp rate hike has cooled the housing market and caused the economy to slow down, but it hasn’t done much to lower inflation,” says Greg McBride, CFA, chief financial analyst at Bankrate.

How the Fed Affects Mortgage Rates

The Federal Reserve doesn’t set mortgage rates, and central bank decisions don’t move mortgages as directly as other products, such as savings accounts and CD rates, do. Instead, mortgage rates tend to move in lockstep with 10-year Treasury yields.

However, the Fed’s behavior sets the overall tone for mortgage rates. Mortgage lenders and investors watch the central bank closely, and the mortgage market’s attempts to interpret the Fed’s actions affect how much you pay on your home loan.

December’s rate hike was the seventh hike in 2022, a year that saw mortgage rates soar from 3.4% in January to 7.12% in October before edging back lower again. “Such increases decrease the affordability of shopping, making it even more difficult for low-income and first-time buyers to buy a home,” says Clare Losey, assistant research economist at the Texas Real Estate Research Center at Texas A&M University .

How much do mortgage rates affect the demand for housing?

There’s no doubt that record-low mortgage rates helped fuel the housing boom of 2020 and 2021. Some think it was the single most important factor that pushed the residential real estate market into overdrive.

Now that rates have risen more than they have in two decades, how will that affect home sales and prices? “Mortgage rates [have] it caused the effective cessation of refinancing activity and a sharp slowdown in home buying activity,” says Mike Fratantoni, chief economist at the Mortgage Bankers Association. Not only have sales slowed, but economists expect prices to fall by a few percentage points to more than 20%.

However, over the long term, home prices and home sales tend to resist rising mortgage rates, say real estate economists. That’s because the individual life events that lead to a home purchase — the birth of a child, marriage, a job change — don’t always conveniently correspond to cycles in mortgage rates.

History bears this out. In the 1980s, mortgage rates soared as much as 18%, yet Americans still bought homes. In the 1990s, rates of 8% to 9% were common, and Americans continued to hoard homes. During the housing bubble of 2004-2007, mortgage rates were higher than they are today and prices have soared.

So the current slowdown may be more a return to normalcy of an overheated market rather than a signal of an incipient crash. “The combination of high mortgage rates and strong growth in home prices in recent years has significantly reduced affordability,” says Fratantoni. “The observed volatility in mortgage rates should decrease once inflation starts to slow and the peak rate for this hike cycle will be visible.”

For now, however, the housing market remains challenging for buyers. “The real estate sector is the most sensitive and most immediately impacted by changes in interest rate policy from the Federal Reserve,” said Lawrence Yun, chief economist at NAR. “Softness in home sales reflects higher mortgage rates this year.”

Yun says the average monthly mortgage payment has risen 28 percent over the past year, a small sticker shock that’s bound to knock over the housing economy. “I expect the pace of price appreciation to slow as demand cools and supply improves somewhat due to increased home construction,” he says.

In fact, the National Association of Realtors (NAR) says the housing squeeze is already easing as demand falls. Homes for sale inventory rose to a 3.3-month supply in October, up from a record low of 1.6 months in January.

Next steps for borrowers

Here are some tips for coping with the rising interest rate climate:

Look for a mortgage. Shopping smart can help you find a better-than-average rate. With the refinancing boom slowing down, lenders are eager for your business. “Conducting an online search can save you thousands of dollars by finding lenders that offer a lower rate and more competitive fees,” says McBride.

Be careful with ARMs. Adjustable-rate mortgages are becoming more attractive, but McBride says borrowers should stay away. “Don’t fall into the trap of using an adjustable rate mortgage as a crutch of convenience,” says McBride. “There is little in the way of upfront savings, an average of just half a percentage point for the first five years, but the risk of higher rates in future years looms large. The new adjustable mortgage products are structured to change every six months rather than every 12 months, which was previously the norm.

Consider a HELOC. While mortgage refinancing is on the decline, many homeowners are turning to home equity lines of credit (HELOC) to tap home equity.

This story was originally published on Fortune.com

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