Why the Fed Wants Home Buyers to Face Higher Mortgage Rates

The Federal Reserve yanked a short-term interest rate higher this week, making it more expensive to borrow money to buy a home or fix it up.

All in the name of slowing inflation.

The central bank raised the federal funds rate Wednesday by 0.5%, or half a percentage point. The Fed hadn’t raised the federal funds rate by half a percentage point in one meeting since 2000.

The 0.5% increase is considered a “hawkish,” or aggressively anti-inflationary, move. Prominent Fed officials had been hinting for weeks that they would deliver a larger-than-usual rate increase, and mortgage rates already had risen sharply in anticipation of it, climbing roughly three-quarters of a percentage point from mid-March to the end of April.

“The speeches that were happening in recent weeks were all about a much more hawkish stance, and that’s really where this drive in interest rates happened,” says Selma Hepp, deputy chief economist for CoreLogic, a property information and analytics provider.

The Fed’s effect on mortgage and equity rates

The Fed’s increase will cause other interest rates to rise, some directly and others indirectly.

A higher federal funds rate will directly increase rates charged on adjustable-rate home equity lines of credit. They will rise 0.5% within a billing cycle or two. These loans, also called HELOCs, are often used to pay for home renovations.

The Fed also has an indirect impact on mortgage rates, which went up steadily through March and April because the markets knew this increase was coming. Mortgage rates are likely to keep climbing, because the Fed has raised the federal funds rate just twice in this cycle and the markets expect several more increases.

Lawrence Yun, chief economist for the National Association of Realtors, noted that the rate on the 30-year mortgage has risen far more this year than the federal funds rate. “This implies that the market is already pricing in around eight to 10 rounds of [Fed] rate increases this year,” Yun said in an email. “​​If inflation turns higher, then the Fed will need to be even more aggressive, and this will further bump up mortgage rates.”

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How expensive mortgages shrink inflation

Typically, the Fed raises the federal funds rate 0.25% at a time. But no one would call today’s economy typical. The Consumer Price Index, a gauge of inflation, hit 8.5% in March, its highest level in more than 40 years. The Fed is demonstrating its seriousness about reeling in inflation by hoisting the federal funds rate by twice the usual increment.

“We really are committed to using our tools to get 2% inflation back,” Fed Chair Jerome Powell said April 21 during a panel discussion presented by the International Monetary Fund.

You might consider raising homebuying costs an odd way to wrangle control over runaway price increases. But higher mortgage rates could slam a lid on fast-rising house prices, because many home buyers shop with a monthly payment in mind. As mortgages become more expensive, home buyers may be forced to shop for less-costly houses, which could slow the pace of home price increases and, in turn, restrain inflation.

Take the hypothetical example of someone who can afford $1,700 a month for mortgage principal and interest, and who began shopping for a house in February. Back then, the 30-year fixed-rate mortgage averaged around 4%. Let’s say our house hunter finally made a successful offer in late April, when the 30-year mortgage had risen to around 5.25%. Here’s how the rate increase affects the amount this buyer can afford to borrow:

• At 4%, the buyer can afford to borrow $356,100.

• At 5.25%, the buyer can afford a $307,900 mortgage — a loss of $48,200 in borrowing capacity.

HELOC borrowers and home sellers aren’t spared

Higher interest rates affect more than home buyers. They change the math for HELOC borrowers and home sellers, too.

Interest rates on variable-rate HELOCs are tied to the prime rate, which moves in lockstep with the federal funds rate. Homeowners with balances on their HELOCs may see their interest costs rise as the interest rate goes up. For every $50,000 owed on a HELOC, a 0.5% interest rate increase raises the monthly interest by $20.83.

Home sellers must keep in mind that higher mortgage rates reduce affordability. It might be worthwhile to check whether buyers’ preapprovals are based on current mortgage rates instead of the lower rates of a few weeks ago.

And with fewer people able to afford homes at today’s higher mortgage rates, sellers may discover that they no longer can count on attracting multiple offers. This situation is worth taking into account when setting an asking price.

May mortgage rates forecast

Mortgage rates are more likely to rise than to fall in May, because the Federal Reserve might send signals that it will continue to raise short-term interest rates in half-a-percentage-point increments at its June and July meetings. If the central bank pursues that sort of aggressive approach to monetary policy, then mortgage rates will almost certainly rise to keep up.

If, instead, mortgage rates fell, the most likely cause would be a geopolitical crisis.

What happened in April

At the end of March, I predicted that mortgage rates would keep going up because they weren’t done rising. This forecast was equivalent to looking out the window of a plane three minutes after takeoff and predicting that the plane will keep climbing for a while. In other words, I didn’t base the prediction on deep analysis. I metaphorically looked out the window.

I guessed correctly. Mortgage rates skyrocketed. The rate on the 30-year mortgage averaged 5.09% in April, up from March’s 4.37% average.

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Holden Lewis writes for NerdWallet. Email: [email protected]. Twitter: @@HoldenL.

The article Why the Fed Wants Home Buyers to Face Higher Mortgage Rates originally appeared on NerdWallet.