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A rise in interest rates is a signal that the Federal Reserve believes the economy is healthy enough that borrowing costs should return to normal levels. This would help keep inflation in check. However, a rise in interest rates could cause some short-term volatility. Economic recovery could slow down; wages may decline, and borrowers would have to pay more for assets, such as houses.
Effect on Mortgage Rates
Increasing the interest rate does not necessarily result in a proportionate increase in consumer mortgage rates. From 2000 to 2017, there has been only a small amount of correlation between the short-term federal funds rate and the long-term 30-year fixed mortgage rate. In fact, it's fairly common for 30-year mortgage rates to move on their own, independent of other economic factors.
For example, from 2004 to 2006, the Federal Reserve increased short-term interest rates from 1 to 5.3%. Over the same period, mortgage rates increased from 5.8 to 6.3%. While interest rates increased by more than 4%, it resulted in only a 0.5% increase in long-term mortgage rates.
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Long-term mortgage rates move as a result of many factors, such as the federal funds rate. Other factors that affect mortgage rates include the inflation rate, the erosion of purchasing power of money, the budget deficit, and household savings rates.
Therefore, an increase in the federal funds rate will only have a small effect on long-term mortgage rates and the overall housing market. However, it's assumed that the federal funds rate will increase fairly steadily over the next two years, reaching an estimated 2.5%. There is likely to be an announcement of an interest rate increase each quarter, and consumer confidence may waver.
Increasing Mortgage Rates
Similar to the federal funds rate but somewhat independent of its movements, some experts say the 30-year fixed mortgage rate is expected to increase over the next two to three years. However, the perception that the potential rise in the federal funds rate is causing mortgage rates to increase is incorrect. If inflation turns out to be higher than expected, it could be the cause of an increase in mortgage rates. Additionally, if the current housing shortage persists with new housing developments lagging behind population growth, it will increase apartment rents, owner-equivalent rents and mortgage rates.
With inflation rates and housing prices making up 30% of the consumer price index (CPI), they are the most significant factors in terms of whether mortgage rates increase in the future. If the Federal Reserve can contain the budget deficit and if home builders become more active, mortgage rates should only increase slightly, even if the federal funds rate increases significantly.
While currently 30-year fixed mortgage rates sit at 4.00% as of Jan. 10, 2017 even if 30-year mortgage rates increase above 6%, it shouldn't alarm consumers. The average mortgage rate was 9% in the 1970s, 13% in the 1980s and 8% in the 1990s.
Also, increases in the 30-year mortgage rate are a signal that the economy is improving and the job market is strengthening. Underwriters will be more relaxed in writing loans, and the pool of homeowners will increase in size. Therefore, it's economically possible for consumers to take on higher mortgage rates; the housing market will be fine, even in light of an increase in the federal funds rate.
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