How A Fed Rate Drop Affects Home Buyers And Sellers

In September 2024, the Federal Reserve (Fed) lowered the target for the federal funds rate for the first time since March 2020 as the pandemic was tough on the economy. This was followed by 11 straight rate hikes to get inflation under control. We’ll discuss the recent Fed rate drop and why several more are expected, and the chance given if you’re getting a mortgage.

What Is A Fed Rate Drop?

A Fed rate drop occurs when the Federal Open Market Committee (FOMC) within the Fed lowers the target range for the federal funds rate. The federal funds rate is the rate at which federally insured banks borrow from each other overnight so they have the capital to maintain their operations.

The actual rate at which the participating banks in the transaction borrow from each other is negotiated between the parties, but the Fed sets the upper and lower bounds within which these negotiations take place.

Officials don’t control the Fed funds rate range on a “because I said so” basis. The range is controlled based on the sale or purchase of assets like securities and treasury notes. This is controlled by the trading desk of the Federal Reserve Bank of New York. These trades control how much funding the Fed puts into or removes from the economy.

The rate at which banks borrow money matters because the cost is passed on to the consumer in either direction. If the federal funds rate goes up, all consumer interest rates rise along with it. Lower federal funds rates mean lower borrowing costs.

Why Do Federal Interest Rates Change?

As mandated by Congress in its charter, the Fed has two primary goals in the area of monetary policy: promotion of the conditions for maximum employment and maintaining stable prices. Unfortunately, it’s often the case that these two objectives are at odds with each other.

Maximizing employment typically involves keeping interest rates low because that makes borrowing funds cheap. If money is cheap, people spend more of it. This encourages businesses to expand and hire more workers to keep up with demand. However, this also can lead to higher prices because people are willing to pay more if they have more cash.

If prices are rising too fast, the Fed raises interest rates. If the cost of borrowing money goes up, people cling more tightly to the funds they have, meaning they spend less. Businesses are also incentivized to drop or maintain prices, which slows inflation. But people buying less tends to lead to layoffs, which hurts employment goals. The Fed is performing a constant balancing act.

Since 2012, the Fed has committed to setting policy consistent with maintaining an annual inflation level of 2%. Officials have determined this is a sort of butter zone. Inflation is just high enough at this level that it encourages spending now rather than waiting, which keeps the economy going. At the same time, the money people have saved isn’t devalued too much.

The target range for the federal funds rate changes when the Fed feels the need to shift the direction of policy in one way or the other based on economic conditions.

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 home 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 fact that traders try to front run federal funds rate moves means that it’s often not beneficial to wait for the Fed in a rate drop situation. If the announcement or projections lead the market to think rates will be higher than it was anticipating the future, mortgage rates could rise following the announcement even if the federal funds rate drops.

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 life 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 basic maintenance and touch ups that are overdue so that you’re showing your house in the best possible light. You also want to get rid of everything you don’t need in your home so buyers can envision themselves in the space. Depersonalize. Finally, price it right. Homes that are priced accurately based on the market are seen as a value and can spark bidding wars.

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.

As mentioned, until recently, the Federal Reserve was in a hiking cycle to try to stamp out inflation under its boot. The Fed rate drop in September came amid a backdrop of recent economic warning signs like a rise in the unemployment rate and lagging numbers in terms of consumer sentiment, manufacturing and services production.

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 influences mortgage rates, these are somewhat less impacted because they have a longer time horizon. They’re driven by purchases of mortgage-backed securities on the bond market. However, they tend to follow the same general direction. If traders can get higher interest rates in other investments, they’ll force higher mortgage yields.

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.

The Bottom Line: Fed Rate Drops Present Opportunity

When the federal funds rate drops, there’s a pretty good chance that mortgage rates follow. Because mortgage rates are set based on expectation, lower mortgage rates often come first. The Federal Reserve has been trying to balance combating inflation without causing a recession, but there’s already been a rate drop with more predicted later in 2024 and into 2025.

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!