How The Federal Funds Rate Increase Affects You

image via businessinsider.com
image via businessinsider.com

If you’ve turned on the news in the last few days, you are likely aware that the Federal Reserve met this week and raised the federal funds rate by a quarter point.

You may be wondering if and how this will affect you and if you’ve missed your opportunity to get a great interest rate on a mortgage.

The media outlets are doing a lot of speculation and making a lot of noise about this change because, well, they’re the media.  Our goal at Armstrong Real Estate is to answer a few basic questions and give you our take on how this could affect your Real Estate decisions in 2016.

Skip down to the bottom of this article to the four action steps to navigate the evolving real estate market if you are not interested in an explanation of the feds funds rate, the reasons for increasing the rate, or how this will likely affect interest rates and the economy.

What is the Federal Funds Rate? Does It Affect Me?

What is the federal funds rate?  In its simplest form, the federal funds rate is the interest rate at which banks lend money to other banks on a short-term basis.   Banks are in the business of lending money.  However, the federal government requires that they keep a certain percentage of cash on hand.  As banks lend out more money and their reserves drop, they can borrow money from other banks that have a surplus in their reserve account so that they stay within the federal requirement.  The federal funds rate is the rate at which they borrow this money.

Why did the Federal Reserve raise the rate?   The federal funds rate is the government’s main tool for guiding the economy.  When the economy is in the dumps, as it has been for a lot of the last decade, they lower the rate to stimulate the economy.  As the economy improves, they raise the rate to prevent inflation.  We aren’t currently experiencing inflation in the US. However, the Fed is acting preemptively to prevent inflation from occurring too quickly in the future.

Why are so many people talking about this increase? Partially because it’s the first increase since 2006, which makes it historically interesting.  But mainly because the Federal Reserve has kept the funds rate close to zero percent, which is akin to keeping our economy on life support, for almost seven years. This increase signals that the Fed feel like our economy is headed in the right direction, and they can slowly begin the process of taking us off life support.  If they are right, this is good news for the overall economy, but it could be bad news for you if you were waiting for interest rates to drop even lower.

Does this increase mean mortgage rates will increase as well? No, not necessarily.  Remember, mortgage rates have fluctuated as much as 2% (from the high 2s to the low 4s) since 2006 while the federal funds rate remained unchanged. The federal funds rate is a short-term rate and mortgage rates are more dependent upon investors desire to invest in long-term rates like the 10-year Treasury and mortgage-backed securities.  Interestingly, mortgage rates did go up by around a quarter of a point over the last few weeks in anticipation of the Federal Reserve announcement.  It was almost a foregone conclusion that the Fed was going to raise the rate, which investors took as a sign that the economy is improving.  This notion of an improving economy—not the federal funds rate increase itself—is what caused the recent mortgage rate hikes.

Will rates continue to rise or could they go back down? Anyone that tells you they have a definitive answer to this question is bluffing.  No one has a crystal ball, and no one knows exactly how the economy will perform this year.  If we were currently experiencing inflation, the unemployment rate continued to drop, and wages were increasing, it would be easier to say with some certainty that rates will continue to rise.  However, there are still a lot of uncertainties as we head into an election year. For what it’s worth, The Federal Reserve and a lot of other smart people believe the economy is heading in the right direction.  If this proves true, then rates may not skyrocket anytime soon, but it’s unlikely they will go back down and very likely they will continue to creep higher in the not too distant future.

What does this mean for my variable interest rate mortgage or my home equity line of credit? If you have a variable rate loan, and you are within an adjustment period, your payment is going up.  Most variable interest rate loans and home equity lines of credit, as well as many credit cards and even some privately held student loans are tied to either the Prime Interest Rate or an index called the LIBOR.  Prime and LIBOR are not directly controlled by the fed funds rate, but they tend to move in the same direction.  While each bank sets their own prime rate, the average hovers around three percentage points above the funds rate.  Since the funds rate went up a quarter of a point, so did the average prime rate, and thus your payment will increase accordingly.  If the Federal Reserve continues to increase this rate, your payment on these types of loans will continue to increase as well.

Ok, then how should I respond and what should I do with this information?  Maybe nothing. If you:

  • have a fixed interest rate home loan
  • don’t have a home equity line of credit or other variable rate loans
  • don’t plan to buy or sell a house anytime in the next several years

then feel free to stop reading and get back to your last minute Christmas shopping.

However, if none of the above apply to you, then here are four tips to help you navigate the evolving real estate market.

Four Tips to Navigate the Evolving Real Estate Market

  1. Now is a prudent time to consider refinancing an adjustable-rate mortgage especially if it is already in the adjustment period or the adjustment period is coming up any time soon. Rates are still historically very low and refinancing now will allow you to avoid the risk of future increases.
  1. If you have an equity line of credit make sure you are comfortable knowing your payment is likely to rise gradually. Don’t take out more equity if an increase in payment would put you in an uncomfortable spot.  If you are already in an uncomfortable spot and an additional increase would be harmful to your financial situation, then consider consolidating to a fixed rate loan.
  1. If you’ve been on the fence about buying a home, now may be the right time to make a move. If rates continue to increase, your purchasing power will go down unless home prices also drop – which we have yet to see signs of. For every one percent increase in interest rate, you lose about ten percent of your purchasing power.  For example, if you qualify for a maximum of a $300,000 home loan at current interest rates and those rates go up by one percent, you can now afford ten percent less, which would be a $270,000 home loan.  If you are having a hard time finding a home you like at your current pre-approval amount and prices in your desired area are continuing to increase or even remaining stable, imagine how difficult it will be to find a home you like for even less money.  Rental rates are also at an all time high so don’t miss out on an opportunity to own a home you can comfortably afford and avoid getting stuck in an overpriced apartment.
  1. If you are thinking about selling your home, trading up, downsizing or moving to another location, now may be the right time to maximize your profit. If rates continue to rise, it may take some buyers out of the market because they can no longer find what they are looking for at a price they can afford.  The fewer buyers in the market, the less competition, and the less competition the less ability you have to maximize the sale price of your home.  The recent mortgage rate increase will likely have an effect on buyers who have been on the fence about buying (for the reasons mentioned above).  Now could prove to be a great time to sell while the inventory of available homes is still relatively low and there is competition among buyers to find a home before rates go up any more.

Our goal at Armstrong Real Estate is to be your one stop shop on all things real estate. If you need to learn more about how the changing economy will affect your home search, or want to to explore buying or selling a home, it would be our pleasure to guide you through the process.  Call us today at 615-807-0579 or visit us online at ArmstrongRealEstate.com.  We want to earn the right to be your Middle Tennessee real estate economist and your real estate agent of choice.

 

Written by: Aaron Armstrong.  Aaron Armstrong is the founder of Armstrong Real Estate with Keller Williams Realty, one of the top real estate sales teams in Tennessee and the top 1% in the country.  Aaron is also a national real estate speaker, trainer and coach.

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