An increase in short-term interest rates will result in increased mortgage rates. This may be a statement of the obvious, but the potentially valuable implications for real estate investors may be less so.
The United Stated operates with a centralized banking system, and the single central bank, the brain that governs all the banks in the country, is known as the Federal Reserve System, usually abbreviated to the Federal Reserve or "the Fed."
The institution within the Federal Reserve that interests us the most is the Federal Open Market Committee (FOMC), consisting of seven governors of the Federal Reserve Board and five Federal Reserve Bank presidents. The committee meets eight times a year, and every stock exchange, every bank, every financial professional waits for outcomes of these meetings — because at those meetings the committee regulates the monetary policy of the United States, and by doing so, controls the activity of all American financial institutions.
One crucial instrument of such control is the unified short-term interest rates handed by the committee to the banks. These are the rates at which financial institutions are allowed to give each other extremely short-term loans. In simplified terms, that is the rate at which the Federal Reserve sells money to the banks — and then the banks re-sell it to their customers (we, the people). The short-term interest rate is, quite simply, “the cost of money” — it defines all the other interest rates in the American financial industry.
The short-term rates are raised (or lowered, but lately mostly raised) when the FOMC decides that the national economic conditions allow — or require — raising them. According to OECD, in the U.S., short-term interest rates reached the historic peak in the early 1980s, hitting over 18% per annum, and are currently within the range of historic lows. Note that the highest short-term rates in the U.S. coincided with the highest mortgage rates (download required) reported by Freddie Mac: In 1981, the mortgage rates reached the historic high of of 18.63%.
Since that time and all the way to the very recent past, the short-term rates continued to drop, until they reached the historic low of 0.11% in May 2014. The mortgage rates declined along the same descending sinusoid, reaching the historic low of 3.41% for 30-year fixed-rate mortgage on the week ending on July 7, 2016.
Ever since the historic low, short term-interest rates and mortgage rates continued to grow — steadily, consistently and, most importantly, synchronously. The current short-term interest rate is 2.17% per annum. Not surprisingly, mortgage rates are on the rise as well, as we’ve seen over the last few months. According to Freddie Mac, over the last year the rates for 1/5, 15- and 30-year mortgages grew by approximately 0.5%–0.6%, with the average rate for 30-year fixed-rate mortgage at 4.59% as of this writing.
Notwithstanding this noticeable growth, we know that the mortgage rates are still near all-time lows. Even when the mortgage rate will climb up to 5% or higher, it will still be less than one-third of the historic high.
There are multiple factors that affect the growth of short-term interest rates, resulting in the growth of mortgage rates. Some of these factors are benign, and others less so: unemployment level, economic inflation, consumer confidence level, total income of the state and so on.
But the main factor that dictates the current raise of short-term interest rates is the demand. Prices climb when the demand is higher, and that applies to the price of money. The growth of the price of money indicates higher demand for money — which means higher demand for the purchasing power due to an increased desire to own things. This means that the growth of the short-term interest rate is not a bad thing — it’s a great thing. It means that Americans are more interested in buying, which means the U.S. economy is on the upswing.
All other things being equal, with the mortgage rates low, I've observed that Manhattan buyers typically find it beneficial to take a "cheap money" loan and make a real estate purchase, because the yearly appreciation of real property in Manhattan (especially, but not only, prime residences) is typically higher than the interest rate on the mortgage. In fact, Curbed reported findings that home prices in the city soared between 2007 and 2017: 27.9% for apartments and a whopping 58.3% for townhouses. Real Deal reported comparable statistics for the 2008 to 2018 period.
Property prices may decline (not by much), but they will inevitably go back up, most likely even faster than ever before. We shouldn’t forget that buyers are eligible for multiple tax deductions: mortgage interest deduction, mortgage interest credit, property tax deduction, mortgage points tax deduction and so on. It’s still good to be a homebuyer.
But what’s especially important is the direction of change of short-term interest rates and mortgage rates. With the U.S. economy steadily improving, both types of rates will continue to increase while still remaining very low. And as every seasoned real estate professional knows very well, when mortgage rates increase, the prices for real estate property begin to drop. We’re already observing this phenomenon today, but what’s particularly remarkable for the Manhattan market specifically is that with current excess of real estate inventory in the city, property prices can be expected to decline significantly, through the combination of the offset of mortgage percentage increase and the arrival of the buyer’s market.
The lesson in all this? With mortgage rates still low but gradually increasing, and prices for real estate on the downturn, it’s a very opportune time to be investing in real estate, and especially in Manhattan. Now's the time to buy, buy, buy.
