Considering Purchasing Property? Do It Before Fed Changes Interest Rates.

All good things must come to an end.

Low interest rates have made real estate a buyer's market for some time now,  but this window of opportunity may be closing sooner than anticipated.

Let's discuss why interest rates were so low in the first place, as well as why we can expect them to change in the near future.

Why Were Interest Rates So Low?

After the ‘Great Recession,’ the Federal Reserve utilized a monetary policy known as quantitative easing. Under the leadership of Ben Bernanke, the Fed began purchasing US Treasury Bills and mortgage-backed securities in order to swell the size of bank reserves. With these excess reserves, banks are more willing to provide loans, which, when spent by consumers, would help stimulate the economy.

This policy lowered interest rates to near zero, and caused mortgage rates to decrease significantly over the past six years.

Consumers have used this opportunity to take out mortgages and buy homes that they may not have considered in a ‘normal’ economic environment. According to Zillow, existing home sales volume has risen by roughly 15%. With lower financing, homeowners can buy a nicer house and pay the same amount per month as their old one, or they could buy a comparable house and lower their monthly payments.

But surely, this trend cannot go on forever.

What Happens As the Proverbial Music Stops? 

This past October, the fed announced its completion of quantitative easing. In the coming years, there will (and already has been) an increase in the cost of borrowing, and subsequently higher mortgage rates. Higher rates not only means it is more expensive to borrow, but it also means that you would have accrued more in a savings account or by investing in safe money market instruments like treasury bills.

How Does a Rate Increase Affect Potential Home Buyers?

Let’s first look at an example (courtesy of Fox Business Reports): A $500,000 home with a 20% down payment and a 30-year fixed mortgage at 4% will cost about $2,481 a month including taxes, interest and insurance, according to Corbett. Over 30 years, once the house is paid off, it will have cost $893,315. Under that same scenario, but with a 5% interest rate, that house will cost $2,688.95 a month including taxes and interest. Over the life of the loan, the homeowner would have ended up paying $968,000, almost $75,000 more. If the rate goes up to 8%, the homeowner would be paying $3,476 a month and the home will end up costing more than $1.25 million. If it were a variable rate mortgage, there would be an automatic change as rates increase. All of a sudden things begin to look less attractive.

When an individual looks at buying a home, they must consider the opportunity costs. If rates are high, they not only will be paying more than normal for the interest on the mortgage, but the opportunity cost of a down payment versus investing that money in a money market account with a relatively high yield is discouraging. Why pay the interest and buy the house when you could earn the interest and rent the house? Or do you want to buy for the investment, seeing the interest as a small cost for a potential increase in overall value in the future?

Higher rates also make it more difficult to pay a mortgage, meaning that many individuals will no longer qualify for a loan. This will inherently lower the amount of eligible buyers in the market, as well as disincentivize real estate investors and developers. 

Take Aways For Prospective and Current Property Owners:

In turn, given these shifting tides, prospective buyers would be wise to move quickly and lock themselves into a fixed rate mortgage when rates are still relatively low.

For those who have already signed on the dotted line and are currently paying off a mortgage -- depending on when you were locked into your rate -- it may be advisable to refinance before the buffet closes for good.