PART I: The Fed Funds Rate
In 2008, amidst the worst financial crisis since the Great Depression, the Federal Reserve implemented a Zero Interest Rate Policy (ZIRP) to keep the fed funds rate below .25%, indefinitely. The theory behind this unconventional monetary policy is simple: low-interest rates typically incentivize investors to engage in high-risk, high-yield investments like stocks and real estate. At a time when confidence in the U.S. economy was at a historic low, the Fed’s commitment to low rates would, hypothetically, encourage spending and rejuvenate the economy.
The status quo remained until December 2015 when the Fed announced it would raise the fed funds rate to .50%, ending the ZIRP after 7 years. The rate was increased once again in December of 2016 to .75%.
What is the Fed Funds Rate?
The fed funds rate is the rate at which banks can lend money to each other on an overnight basis. The higher the fed funds rate, the more expensive it is for banks to lend to each other. When a bank has to pay more to access money, it will (typically) increase the rates for its customers.
The perennial goal of the Federal Reserve is to foster maximum employment (unemployment rate of about 5%) and maintain stable prices (inflation rate of about 2%) and the fed funds rate is one of their primary tools for doing so. Simplistically – if inflation is too high, the Fed can raise the fed funds rate to make it more expensive to access loans. When people have less cash flow, businesses cannot charge as much for good and services thus lowering prices and reducing inflation. On the other hand, if unemployment is high, the Fed can lower the fed funds rate to allow companies access to funds to hire more employees, facilitating an influx of money into the economy.
Does the Federal Reserve Control Mortgage Rates?
There is a common misconception that the Federal Reserve controls mortgage rates; it does not.
According to Dan Green of TheMortgageRates.com, “Over the last two decades, the fed funds rate and the average 30-year fixed rate mortgage rate have differed by as much as 5.25%, and by as little as 0.50%.”
Green argues that if the fed funds rate and mortgage rates were actually linked, “the difference between the two rates would be linear or logarithmic – not jagged.”
The Federal Reserve can affect mortgage rates indirectly. Here’s how:
Mortgage Rates are determined by the value of mortgage-backed securities (MBS) sold on Wall Street. If the value of mortgage-backed securities is high, mortgage rates are low. But when inflation is present in the economy, it drives the value of MBS down and mortgage rates rise. This why Wall Street pays close attention to the statements and actions of the Federal Reserve. If the Fed indicates inflationary pressure in the economy, mortgage rates are likely to rise.
Buying a Home in 2017
The Federal Reserve has suggested it plans to raise the fed funds rate .75% in three increments over the course of 2017 which indicates the FOMC expects a moderate increase in inflation. If inflation continues to slowly rise, mortgage rates will likely follow suit.
Mortgage rates increased for 10 straight weeks to close out 2016, but dipped slightly in the first week of 2017 from 4.32 to 4.20 for a 30-year fixed rate mortgage. Overall, experts predict mortgage rates to rise slowly throughout 2017. Assuming the 2017 week one dip is an aberration and rates continued to climb as expected in January and February, “buyers will come out of the woodwork earlier in the selling season and try to lock in lower rates while they can,” according to David Charron of The Washington Post.
Jon Faust of Hopkins University, says that if President-elect Donald Trump carries through on his promise to use tax cuts and infrastructure spending to grow the economy, inflation and mortgage rates could increase significantly by the end of 2017.
Strong demand and low inventory contributed to home prices increasing at the fastest rate in a decade in 2016, rising 6.5% on the year. Zillow predicts that while home prices will increase again in 2017, the growth will slow to about 3%.
Charron agreed that price growth could slow this year and added that the projected increase in mortgage rates could also be responsible.
“Because more-expensive mortgages make the overall cost of buying a home increase, we may see price appreciation slow down or, if rates rise considerably, prices could tick downward.”
Overall, the market in 2017 is expected to continue to favor sellers, although less so than in years past. The first half of 2017 could see sales close faster than normal with some buyers wary of increasing mortgage rates.
PART II: How the Conforming Loan Limit Impacts Home Sales
Last November, the Federal Housing Finance Agency (FHFA) announced it would raise conforming loan limit in 2017. This is the first increase of its kind since 2008, when the conforming loan limit for a single-unit home was set at $417,000 in an attempt to stabilize the economy in the wake of the financial crisis. The Housing and Economic Recovery Act of 2008 dicates that the conforming loan limit is to be fixed at $417,000 until average U.S. home prices returned to pre-crisis levels. In the third quarter of 2016, home prices finally surpassed those of 2007, thus ending the nine-year freeze.
What is the conforming loan limit?
The conforming loan limit dictates the maximum size of a mortgage that Fannie Mae and Freddie Mac can guarantee to a bank. Often, when a bank grants a mortgage to a home buyer, the bank will then sell the loan to Freddie Mac or Fannie Mae. That way, the bank recovers the entire loan amount immediately, instead of having to wait 15 or 30 years to be repaid in full by the homebuyer.
The conforming loan limit dissuades banks from granting exorbitant (risky) loans to homebuyers because the bank will not be able to sell the loan off to Fannie Mae or Freddie Mac. Conforming loans are considered lower risk, and therefore, typically qualify for lower down payments and lower interest rates.
A home loan that exceeds the conforming loan limit is known as a jumbo mortgage. Because these cannot be purchased by Fannie Mae or Freddie Mac, they are either sold to outside investors as part of mortgage-backed securities, or retained by the bank.
Impact on Home Sales in 2017
For most of the country, the conforming loan limit has been lifted to $424,000 for a one-unit home. The loan limit will be higher in counties where 115% of the median home value exceeds $424,000. In those instances, the limit is set to $636,150 (150% of the baseline $424,000).
The increase in the conforming loan limit will allow qualified buyers access to a larger home loan which will increase purchasing power, so experts say real estate agents should be on the lookout for eager and able buyers in 2017. This, combined with buyers’ urgency brought on by increasing mortgage rates, could mean that the first two quarters of 2017 see homes sold a particularly fast rate.
It is important to remember that while loan limits have increased, lending standards have not softened. So, the average buyer will still need to have a healthy credit score and be able to make a downpayment in the 5-10% range in order to qualify for a conventional mortgage.
PART III: The Real Estate Market will Grow in 2017
Home Prices Will Rise (Slowly)
Several industry leaders have suggested that home sales will continue to rise in 2017. However, the growth will be more moderate than in 2016; which saw the fastest increase in a decade at about 6.5%, according to Zillow.com. The extent to which growth will slow remains uncertain.
More People Will Have Access To Loans
As discussed in our 2017 Housing Forecast Part II, the conforming loan limits have risen for 2017. This will grant well-qualified buyers access to larger home loans – the limit for a single unit home in the majority of the country is up from $417,000 in recent years to $424,000 in 2017.
With access to more money, home buyers will now be able to purchase more expensive homes, which experts say could cause homes that sat in market in 2016 to be scooped up quickly in 2017.
Mortgage Rates Will Rise
The FOMC plans to raise the Fed Funds rate three times in 2017. This suggests that the Federal Reserve expects a moderate increase in inflation in the economy, which will trigger mortgage rates to increase as well. So, while the new conforming loan limit will give buyers access to larger loans, it will likely cost more for access to those loans. This explains why experts believe real estate spending will only moderately increase in 2017.
According to the Washington Post, “Sellers have finally regained enough equity in their homes to feel comfortable putting them on the market.” Also, with mortgage rates expected to rise, homeowners who are considering selling in the next few years might get their property on the market sooner rather than later; if they wait, they risk selling for less than they could get right now.