Rising Interest Rates? Here Is How to Prepare
Eight times a year, investors around the world tune in for news from the Federal Reserve (the Fed). Behind closed doors, members of the Fed’s monetary policy committee discuss the nation’s economy and central bank affairs before arriving at an important conclusion—the federal funds rate or the interest paid by borrowing banks. Changes in the federal funds rate then ripple down to the consumer level, affecting interest rates across the board.
For investors in real estate, equities, fixed income, and other financial securities, federal fund rate changes and the subsequent interest rate shifts can have a huge financial impact. The financial systems around the world are built upon a system of lending and borrowing, and for those heavily involved, even small shifts of 25 basis points (0.25%) in interest rates can equate to thousands or millions of dollars gained or lost. The Fed, cognizant of the effects of interest rate changes, provides investors with a forecast and federal funds rate target range, allowing investors to prepare and make necessary adjustments.
Interest rate cuts and affect homeowners, landlords, and real estate investors differently. While an increase in interest rates directly results in higher mortgage rates, changes can cascade across into property values and rental rates.
The Federal Funds Rate Outlook
Prior to the COVID-19 pandemic, interest rates were hiked after a nearly decade-long period of historically low rates. As the economy recovered from the 2007-2008 financial crisis, the Fed slowly began raising interest rates, reaching a high of 2.5% in December 2018.
When the COVID-19 pandemic hit, the Fed quickly dropped rates down to 0.25% in an effort to support economic activity, labor market conditions, and inflation levels. As the world recovers from the pandemic, the Fed has continued to keep rates at near-zero levels. In a statement made in December 2020, the Fed reiterated its commitment to low-interest rates and the recovery of the labor market.
However, with mass-vaccination just over the horizon, economic recovery, accompanied by increasing interest rates, looks to be just around the corner.
How Changes in Interest Rates Affect the Real Estate Market
Typically, rising interest rates equate to tighter credit and more expensive borrowing, increasing friction in the market and making transactions more difficult. On the flip side, falling interest rates make borrowing easy, allowing for easier purchases and sales.
Because rising interest rates make borrowing more expensive, potential homebuyers often decide to put off purchases.
For example, if Sue wants to purchase a $650,000 house with $150,000 down, she will have to take $500,000 out on a mortgage loan. If she decides to take a 30-year fixed-rate mortgage out at 4% interest, she will make monthly payments of about $2108. If the interest rates rise to 5%, this same mortgage on the same house now requires payments of $2387, a monthly difference of $279.
As rising interest rates decrease the relative affordability of mortgages and homes and slow down the housing market, prices often subsequently fall. In essence, as demand for houses drops, prices drop to compensate. The opposite also occurs with falling interest rates, which typically leads to increasing real estate prices. Finally, high-interest rate volatility increases investor risk without increasing rewards, resulting in lower prices, with the converse also being true.
Rising interest rates are also typically correlated with rising rent costs. As interest rate increases make housing less affordable, more potential homeowners look to rent instead, increasing demand in the renting market with consistent supply.
How You Can Prepare for Rising Rates
Different interest rate trends are often correlated with changes in the real estate market, allowing investors, homebuyers, and landlords to adjust their strategies in advance. Making the right moves ahead of a Fed rate cut or hike can result in a large windfall for investors and landlords, while homeowners can save tens of thousands of dollars.
Tips for Homebuyers
For homebuyers, the prospect of rising interest rates can put time pressure on a purchase and increase activity in the market. Currently, the near-zero rates have created a haven for homebuyers, often resulting in bidding wars and offers made above asking prices. If interest rates rise, this may dampen homebuyer enthusiasm, resulting in a downwards adjustment in prices that compensate for increasing mortgage rates.
While buying during low-interest and high-interest environments both have advantages, the decision between fixed-rate and adjustable-rate mortgages often has higher financial consequences. While the extremely low monthly payments of adjustable-rate mortgages may look attractive in the current low-interest rate environment, rising interest rates may quickly put a damper on the excitement. As interest rates rise, the rate of an adjustable-rate mortgage initially taken out at 3% may quickly balloon upwards, costing the homeowner thousands. Instead, fixed-rate mortgages allow homebuyers to lock-in interest rates for the entire duration of mortgage payments, allowing homebuyers to take full advantage of temporary low-interest rate environments.
Currently, low-interest rates have created an environment with many homebuyers and fewer renters. Savvy homebuyers with cash on hand may benefit from waiting until the lower prices of a high-interest rate environment, capitalizing on lower rental demand in the low-interest environment by living in a home for rent.
Tips for Landlords and Real Estate Investors
As interest rates and mortgage rates have dropped down to rock-bottom levels, many real estate investors and prospective landlords have invested in new properties, taking advantage of cheap credit. However, if interest rates rise, investors and landlords caught holding adjustable-rate loans may find themselves facing disaster. Rising mortgage payments, combined with rental property maintenance costs and property taxes, may even force an investor or landlord to sell at an inopportune time. When facing risks from potential interest rate hikes, refinancing adjustable mortgages into fixed-rate mortgages may allow investors to lessen risk and take advantage of low rates.
For investors and landlords looking to buy-to-lease or buy-to-rent, a low-interest rate environment with rising rates on the horizon is the perfect opportunity. By investing and locking in low, fixed-rate mortgages, buyers can reap the rewards in high-interest environments by renting out at higher prices.