The prospect of future interest rate hikes by the Federal Reserve is a lingering concern for potential homebuyers. What do interest rate hikes really mean for ordinary borrowers? Past experience shows that these increases could lead to the growing costs of purchasing a home and, when this happens, unfortunately, access to homeownership will inevitably be decreased.
This is why, even though the Fed is not the one responsible for setting mortgage rates, mortgage industry players are still watching its actions very closely. The way the mortgage market views the Fed’s actions impacts how much borrowers actually pay for their mortgage loans.
Following FOMC Moves
What should prospective homeowners expect, especially those who have an adjustable-rate mortgage in this current rising interest environment? Dissecting what the Fed's actions mean is key to answering this question.
The Federal Reserve raising rates merely means that the target for the federal funds rate has shifted. The federal funds rate is essentially the Federal Open Market Committee (FOMC)-set target interest rate. This is the rate at which commercial banks borrow as well as lend to each other. On the borrower level, this means that the federal funds rate can affect short-term rates on consumer loans.
Through hints in their public remarks, the members of the FOMC usually give investors some insight as to whether the Committee plans to increase or cut short-term interest rates. Thus, by the time the FOMC meets, there is typically already a consensus among investor circles on what the Fed will do with regard to rates.
As that consensus becomes more concrete prior to an FOMC meeting, mortgage rates usually follow the anticipated trend that market players believe the Fed is leaning toward — whether they will cut, raise, or keep the rates as they are. Often, by the time of the FOMC meeting, mortgage rates already reflect the expected rate change. So if the Committee decides to raise interest rates, mortgage rates will likely follow suit. The problem is that the now-higher mortgage rates obtained by borrowers affect their monthly payment as well as the price of the loan throughout its life.
Mortgage rates do not always follow Fed increases, instead they move in tandem with the expected yield on the 10-year Treasury note. Shifts in the federal funds rate could potentially move the rate on government-issued 10-year Treasury bonds. Fixed-rate mortgages are linked to the 10-year Treasury rate in the sense that when that rate goes up, the 30-year fixed-rate mortgage usually does the same and vice versa. The yield on the 10-year Treasury note has reached close to 3.6%, which is its highest point since 2011.
Effect on the Different Types of Mortgages
On top of these, the rates for fixed mortgages are also affected by other factors, such as the supply and demand for the product. When mortgage lenders have too many loans to process, many of them intentionally raise rates to curb the demand while doing the opposite when business is not as good. The Fed’s actions also indirectly impact the rates consumers pay on their fixed-rate home loans when they refinance or when they take out a new mortgage.
According to Experian, financial institutions place a 3% addition to the federal funds rate when the banks are setting the prime rate for their clients. The current federal funds target rate is 1.50% to 1.75%.
Meanwhile, for those with fixed-rate mortgages, rising rates will have no effect on their loans. In other words, the interest rate and the monthly payment will stay the same. But, rising interest rates can raise borrowers’ monthly payments if they have an ARM, and fixed mortgage rates might be costlier for those with new home loans, Experian stated.
The combination of the recent mortgage rates increase mixed in with an already hot real estate market is increasing monthly payments on new mortgage loans. Experian says that the principal and interest payment for the median U.S. home has risen roughly $600 (44%) from the start of 2022, and $865 (79%) from pre-pandemic levels. A 2% rise in interest rates is an added $115 to a monthly payment for every $100,000 of a 30-year home loan.
At issue here is the fact that the higher home price affects a borrower's debt-to-income ratio or DTI, which is a key element lenders look at when they approve mortgages. Of course, keeping one’s DTI low can help in qualifying for a home loan and other types of loans. In real estate, lenders want housing payments to only comprise nothing over 28% of borrowers' gross monthly income. Additionally, most lenders want a borrower’s debt-to-income ratio to not exceed 36%, although some lenders or loan products might require a lower percentage to qualify.
Thus, the problem is that increased monthly payments are probably going to make it more difficult for borrowers to qualify for home loans they could have afforded otherwise prior to rate hikes, impairing affordability and the ability of many more people to obtain mortgages. This is true, even if the home price stays the same.
That’s why Arrive Home believes so deeply in its mission to help make homeownership possible for all responsible borrowers by working with other entities to provide down payment assistance. Now, more than ever, borrowers need creative solutions to achieve their homeownership dreams. Contact the Arrive Home team to learn more about the options that could make purchasing a home more affordable for you.