The Federal Reserve is the central banking system for the United States Government, but it’s more commonly referred to as “The Fed.” It’s the central hub for American money and according to the objectives set out by Congress, the Fed is in place to maximize employment, and control financial variables like the price of goods and interest rates. As of late, interest rates seem to be the hot topic when it comes to American money; it affects everything from our nationwide gas prices to the weekly grocery bill. Loosely, it feels like a larger, more macro-level, economic concept that has a very minor influence on your personal real estate investment. But, as interest rates influence the banking system, and your banking system affects your mortgage eligibility, it’s easy to see how the Fed becomes a larger and more present concern. So, let’s break it down, step by step.
The Federal Reserve impacts home equity in two ways: first by tightening the money supply overall and second by banks thereby having less money to lend. The primary effect of raising interest rates is that it costs more money to borrow large sums, which means the average American can afford less than they previously could for the same amount of money borrowed. A decreased supply of money from the Fed happens irrespective of a constant – never mind increased – demand for larger loans, like mortgages. In short, the risk is higher.
How are the banks supposed to guarantee that they’ll get their money back from you, the borrower, when the Fed is restricting the supply of money? That leaves the banks with two options. They can look for higher quality borrowers with higher credit scores, raising the bar on who is eligible for mortgage loans to begin with, and/or buying treasury bills with the money they have on reserve as opposed to loaning it out. Either way, the money banks have on reserve is being given to borrowers less and less.
Specifically when it comes to mortgage rates, the Federal Reserve influences mortgage rates by setting “the overnight rate.” In short, it’s the banks’ cost of funds. The overnight rate is the interest rate that large banks use to borrow and lend from one another in the overnight market. The Federal Reserve influences this by setting the minimum amount that banks have to pay in order to borrow US dollars. This is easier to envision if you imagine the Fed as your bank’s bank. The same way borrowers are impacted by increased interest rates, banks are paying more money regarding their borrowing needs as well. There is no such thing as “free money.” So, banks paying more money in interest means that investors are paying even more money. Let’s not forget that banks are businesses, not your personal piggy bank.
By now, it’s easy to see how this quickly becomes a chicken-or-the-egg paradox, so let’s keep going. The largest influence on determining mortgage rates is the bond market. The bond market is a free and open market where people trade US debt, and as a result it is the ultimate dictator of what interest rates will be. The bond market for US debt is the purest form of capitalism that exists on the planet because it cannot be manipulated, hacked, or worked around, and it’s backed by the good faith of the US government.
If you’re investing in real estate, what does this mean for you, other than refinancing your home when the interest rates inevitably drop in the future? First, it’s important to figure out for yourself if you’re a home buyer or an investor. If you’re looking to buy a piece of residential real estate because you have needs based on certain life changes, like marriage, children, wanting a bigger yard for a dog or agriculture, you’re a home buyer. For you, there is no time that will ever feel right or wrong. The only time you’re responding to are the ones in your life that are prompting you to buy a home in the first place. While buying a home is an investment, it is based upon personal needs and is dictated by when that need comes about. Sure, the interest rates aren’t going to help you feel like this is the supposed “right” time to invest, but like with any major life change, the “right” time will never come. No one feels ready, they just do it. However, I suspect that deep down, you know you’re ready. That’s why you no longer want to buy a home, you need to buy a home.
If you’re an investor as opposed to a home buyer, my advice to you is more or less the same. Philosophically, there is still no “right” time. However, your need is now represented by the deal making the most sense. Whether interest rates are high or low, the market will adjust and offer opportunities. As a smart investor, your parameters for success should adjust as the market adjusts. Otherwise, much like the home buyer looking for the “right” time to buy, you’ll never jump in and invest your equity in something that’s almost guaranteed to appreciate in value over time. In the same vein in which you’ll look back on pictures from your youth, how young and beautiful you were, and immediately regret every second you spent feeling self conscious, you will also likely look back on this time, regretting the properties you didn’t buy. This may not be trendy, but it is absolutely true.