Source: Forbes —
By now you’ve probably seen that interest rates are on their way up. The Fed has been raising rates for a number of quarters now in an attempt to wind down the sky high levels of inflation. So far they’ve not had much luck on that front, but there’s one major area that has been heavily impacted.
Mortgages.
The rate of the average mortgage has gone through the roof in recent months, which is making it even harder for first time buyers to get on the property ladder.
At the start of 2022 the average 30 year mortgage rate was around 3%. Mortgage rates have been low for a while now, but at the start of the year they began to creep up. Now, average mortgage rates have risen to over 7%.
That’s a huge difference.
A few percentage points may not sound like a lot, but they really add up when you’re talking about a mortgage of a few hundred thousand dollars. For example, on a mortgage of $300,000 the increase from 3% to 7% would mean the average monthly payment has increased from $1,265 up to $1,996.
That’s an extra $731 per month, on top of the already rocketing prices of everything else. It’s no wonder that potential new home owners are having second thoughts on whether they can afford to buy.
But how does the Fed increasing interest rates impact what a homeowner pays for a mortgage? Let’s look into it.
How higher Fed rates increase mortgages
Essentially any type of loan is based on the base rate set by the Fed. It’s called the base rate because it’s the rate on which all other interest rates are ‘based’. In practical terms, the Fed’s rate is what the banks themselves pay in interest for short term borrowing.
Short term borrowing is a fundamental part of the financial system, with money flowing around so fast that it can’t all be accounted for and transferred instantly.
Because of that, the more interest that they themselves pay, the higher interest they need to charge to their customers to maintain their profit margins. If the Fed raises rates, banks pay more interest and they therefore need to increase the interest they charge to their customers.
If the Fed reduces interest rates, the banks pay less interest which means they can reduce the interest they charge to their customers.
These interest rates flow through to any form of debt you can think of. Mortgages and auto loans are probably the biggest ones, but there’s also credit cards, unsecured personal loans, bank overdrafts, student loans and business loans.
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