How Do Interest Rates Affect Homebuyers?

The Federal Reserve is the central banking system of the United States. It uses a technique called monetary policy to control various aspects of the economy. These aspects may include stabilizing economic growth, lowering unemployment, or even maintaining predictable exchange rates with other currencies. One of the approaches commonly used when setting monetary policy is to raise or lower interest rates. When an adjustment is made to interest rates, a 12-18 month chain reaction is set in motion. For example, when the Federal Reserve raises interest rates, banks raise their prime rate. This, which in, turn affects mortgage rates, car loans, and credit card rates as well as business and consumer loans.

The Federal Reserve use a combination of contractionary and expansionary monetary policies to achieve different economic results. When the Federal Reserve raises interest rates, it is using contractionary monetary policy. As the name suggests, this policy is meant to “contract” or “cool off” a rapidly growing economy. When rates increase, adjustable-rate mortgages become more expensive. Home buyers can only afford smaller loans, which slows the housing industry. Housing prices go down, so homeowners have less equity in their homes and feel poorer. They spend less, which further slows the economy.

Changes in interest rates directly effect a buyer’s purchasing power. When rates increase 1% a buyer’s purchasing power is reduced by 10%. As an example, when interest rates increase from 3.5% to 4.5%, a buyer who would have been approved for $500,000 is now going to be approved for around $450,000. Although there are many factors to consider when deciding to purchase a home, interest rates will undoubtedly play a significant role in a buyer’s final decision.

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