How Interest Rates Affect The Housing Market

You hear it all the time.  The federal reserve decided today to raise, cut or hold steady interest rates. Why is this so important and what does all of this mean to the housing market?  

The Federal Reserve, or FED, is the central bank of the United States.  According to Investopedia, a central bank is a financial institution given privileged control over the production and distribution of money and credit for a nation or a group of nations. One of the primary responsibilities of the federal reserve is to maintain financial stability and the primary way they do that is through interest rates. 

So, what exactly is an interest rate. Interest rate is simply the amount the bank or other financial institution is charging you to use their money to make purchases that you don’t pay for in cash out of pocket. The amount of money you’re actually borrowing is called the principal.

There are four parts to a mortgage payment commonly referred to as PITI – principal, interest, taxes, and insurance.  The first part of the payment, principal and interest, is the part we’re focusing on for this discussion as this is the portion of the housing payment directly impacted by interest rates. Indeed, it’s likely the single most determinant of your mortgage payment. 

Now suppose you’re using an FHA loan to purchase a home for $350,000 at an interest rate of 3.5%.  Using this loan requires you to put down 3.5% which in this example comes to $12,250. The principal and interest portion of your payment will about $1516/mo. A lower interest rate will also increase your purchase power and allow you to get more house for your money than if you purchased at a higher rate.

Now let’s calculate that same loan and down payment using a purchase price of $350,000 at an interest rate of 7%. That puts the PI portion of your payment at $2,247. That’s an increase in your housing payment of over $700/mo. This also means that a higher interest rate will decrease your purchase power so that you may not be able to obtain a house that meets your needs but have to settle for a smaller, less expensive home.  

Simply put, lower interest rates mean a lower mortgage payment and higher interest rates mean a higher mortgage payment.   What this means for the housing market is that fewer people can afford a housing payment of over $2000/mo. than if that same payment was less than $2000/mo. This reduces buyer demand which, in turn, increases the supply of houses on the market as well as the length of time it takes to sell a house.  Ultimately, this will lead to a slowing of the housing market and a slight drop in the price of housing.