How A Fed Rate Drop Affects Home Buyers And Sellers
Sep 19, 2024
6-MINUTE READ
AUTHOR:
KEVIN GRAHAMThe Federal Reserve (Fed) has been consistently raising the target for the federal funds rate for nearly 2 years now in an attempt to bring inflation under control. While inflation has started to calm, persistently rising rates have made an impact across the economy for both businesses and consumers. Now the officials are pivoting to try and help out employment numbers, the state of play has changed We’ve seen the effect of rate increases play out in recent years, but what does a Fed rate drop do – particularly for housing?
Why Would The Fed Cut Interest Rates?
The Federal Reserve Act has set out the monetary policy objectives of the U.S. central bank ever since its modern-day founding. Last amended in 2000, the short paragraph lists three North Stars:
- Maximum employment
- Stable prices
- Moderate long-term interest rates
When you really boil this down, the job of the Fed is really to maintain a balancing act between maximum employment and stable prices. Interest rates are something that officials put their thumb on when one of the other two categories is getting out of whack.
Before we go much further, it should be noted that the Federal Reserve doesn’t impact consumer interest rates directly. Instead, it’s a trickle-down effect. Officials set the target range for the federal funds rate, which is the rate banks borrow money from each other overnight. The bank then passes through their increased or decreased costs to the end borrower. However, even then the Fed only sets a range. Individual transactions are negotiated by the banks.
As mentioned, the Federal Reserve has been in a pattern for a while of raising the target to prevent prices from rising too quickly. However, it’s a balancing act.
If higher interest rates decrease the money supply to the point where people stop buying goods and services, businesses lay employees off, meaning people are buying even less, which can lead to more layoffs. It has the potential to start a cycle where you could end up in a recession or worse.
At the same time, keeping rates too low for too long makes it cheaper to borrow money and consumers are willing to spend more. If this goes on for too long, inflation can run out of control. In an ideal world, the Federal Reserve has a 2% annual inflation target. This is enough inflation to encourage people to buy now while not severely devaluing current earnings.
The Fed is currently aiming for a soft landing, bringing inflation down without causing too much damage across the rest of the economy. Knowing that interest rates have a broad impact on the borrowing abilities of both businesses and consumers, the Federal Open Market Committee (FOMC) – the monetary policy arm of the Fed – looks for signs of pressure on the economy. This includes increasing unemployment claims.
The Fed is looking for more signals that inflation is softening on a sustainable basis. Assuming officials see data supporting this, the majority of the Fed has signaled three rate cuts this year.
The current target range for the federal funds rate is 4.75% – 5%. Quarterly projections show that most participants think the rate will be 4.4% in 2024. In order to kickstart the process of lowering rates and stimulating employment, the target was 0.5% recently.. Projections make 0.25% incremental drops likely at the final two meetings of the year.
Why Has The Fed Lowered The Federal Funds Rate In The Past?
Historically, the Federal Reserve has lowered the federal funds rate as part of its strategy in response to the economic effects of a recession. The last major long-term recession we had was right around 2007 – mid-2009. At the time, the Fed dropped rates 10 times in varying increments between September 2007 and December of the following year.
When it came to the pandemic, the Fed cut rates by 1.5 percentage points over a period of 2 weeks. The goal then was to support the economy as various sectors temporarily shut down, leaving people out of work.
Partly spurred by pandemic-related stimulus and supply chain issues, inflation eventually started to rise at levels not seen in some time. The Federal Reserve raised the target for the federal funds rate 11 times since March 2022, prior to the recent pivot, to work to get it back under control. The Fed is now trying to thread a very fine needle on inflation while keeping unemployment relatively low.
If there’s less money in circulation due to interest rates, consumers tend to spend less, which brings prices down over time. However, raising interest rates too much puts a big damper on both consumer and business borrowing and spending, which tends to lead to recession.
How Does The Federal Funds Rate Affect Other Rates?
While they aren’t expressly correlated, the federal funds rate tends to affect consumer rates. Short-term interest rates, like those associated with credit cards, tend to be the most impacted, followed by personal and car loans.
In terms of how the Federal Reserve’s rates influence mortgage loans, these are somewhat less directly impacted because they have a longer time horizon and are much more impacted by purchases of mortgage-backed securities on the bond market. However, they tend to follow the same general direction.
As the federal funds rate has risen, mortgage rates have generally gone up more or less in tandem. It wouldn’t be a perfect correlation because they move day to day with bonds. By contrast, the federal funds rate range is set and remains the same until the Federal Reserve decides to change it again.
How A Federal Rate Drop Can Affect Home Buyers And Sellers
Because the housing market can be very interest rate sensitive, the federal funds rate and the reaction of the markets to the changes affect both buyers and sellers.
How Home Buyers Are Affected
If the federal funds rate dropped, it’s very likely that mortgage rates would fall. Sometimes it’s not a one-to-one relationship because the market often tries to anticipate what the Fed is going to do with rates. The market does this because mortgage rates lock in advance and they’re also sold on the secondary market up to a couple months after they originate.
The good news is as rates drop, your buying power will rise because you’ll be able to be approved to borrow more money. The home buying process can be harder or smoother depending on how your monthly payment impacts your debt-to-income ratio (DTI). If you need a more expensive house to meet the needs of a growing family, for example, this could make a big difference.
However, lower rates are a double-edged sword in the housing market. Sellers could see increased demand from lower rates as giving them the ability to raise prices. Rock-bottom rates are among many reasons why the housing market persisted with a special level of high demand and higher prices from 2020 – 2022.
How Home Sellers Are Affected
You might think that the right time to sell is when rates are lower on the theory that there will be more demand, which means budgeting a higher price. The only problem with that is you also have to know you can find a house at the same time in most cases. You would also be buying at the top of the market. The better answer is that the right time is when your lifestyle dictates it’s time.
If you’re a homeowner getting your house ready to sell, there are some actions you can take to make sure you’re ready in any housing market, regardless of the interest rate environment:
- Perform whatever fixes you can: Any touch-ups you can make to the interior and exterior of your home can help you put your best foot forward when listing it. Beyond marketability, you’ll need to fix anything that’s considered a health or safety issue if the home is going to pass a mortgage appraisal (think exposed floorboards and missing handrails).
- Make it a show home: Because you might still be living there, you won’t be able to remove everything. However, you want your potential buyer to be able to see themselves in the space. That means plenty of room to walk through and the removal of personal effects as much as you can.
- Price right: If you price appropriately for the demanding market, no matter the interest rate, you’ll be likely to attract more interested buyers and potentially set the conditions for a bidding war. Your real estate agent can help you with a comparative market analysis to determine the right price point.
The Bottom Line
If the federal funds rate drops, there’s a pretty good chance that mortgage rates will also be heading down with it. And while the Federal Reserve is currently trying to find balance in terms of combating inflation without causing a recession, some predict rate drops may be on the way later this year.
While they could be coming, lower rates might also mean higher home prices, so better affordability isn’t guaranteed. The right time to buy or sell a house is whenever you’re ready from a finance and lifestyle perspective.
If you’re ready to get started, apply for a mortgage today!
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