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Watching interest rates rise from 3% to over 8% in a relatively short period has been enough to give anyone whiplash. And it may have been particularly difficult if it happened just as you prepared to buy a home or new car. It’s possible to intellectually accept that the Federal Reserve raises interest rates to combat inflation, but that does not mean you have to like it.
During the pandemic, the world felt wonky. However, the influences that led to higher mortgage rates were, at their core, the same factors that have always driven rate hikes. Here’s what they were and what it will take to stall and reverse them.
There are a couple of basic reasons interest rates increase when inflation is on the rise. The first is that higher interest rates are one important way the Federal Reserve can slow the economy and cool inflation. The other has to do with mortgage lenders needing to earn a higher rate of return to ensure they don’t lose out on purchasing power due to inflation.
As inflation heats up, businesses — including your mortgage lender — look for ways to remain competitive. If they’re going to pay more for rent, supplies, and the other costs associated with doing business, they must find the money from somewhere. By raising the mortgage rate on their loans, lenders can hedge against losses due to inflation.
Stall No. 1: As inflation cools, lenders have fewer concerns about what it’s costing them to do business and can begin to cautiously lower their rates on mortgage loans alongside the Federal Reserve cutting rates.
At 3.9%, the unemployment rate remains low. While that’s great for employed families, low unemployment means consumers have more money to spend on goods and services, including new homes. The more people who can afford to buy a home, the more vital it is that inventory keeps pace. When that’s not the case, anxious buyers begin paying too much just to get in a house. In what becomes a vicious circle, overpaying leads to inflation, and inflation leads the Federal Reserve to raise interest rates.
Stall No. 2: As the economy weakens, companies lay off more employees. Once the unemployment rate begins to climb, the Federal Reserve makes it easier to borrow money by lowering interest rates.
Bonus: As interest rates drop, more current homeowners may be more willing to sell their properties and take out a new mortgage for another house. Once enough homes come back on the market and inventory begins to approach pre-pandemic levels, home prices should cool.
The U.S. is currently enjoying a strong economic period. During these times, governments, businesses, and households each have the urge to spend — often more than they bring in. This desire leads to higher interest rates as lenders know they can cash in on the desire for loans.
Stall No. 3: As economic conditions weaken, fewer people are willing to borrow money. Instead of spending, people begin to stow their money somewhere secure, like savings accounts and certificates of deposit (CDs). Slowly, lenders realize they have more funds to loan than consumers willing to borrow, and interest rates drop.
We can’t say for sure when rates will stall and then begin to fall. However, we can say that there’s nothing about today’s economy to suggest that rates will always be high. Historically, mortgage rates have gone up, and they’ve come back down. It’s a matter of deciding how patient we can be as it all plays out.
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