Last Thursday, January 16, mortgage rates climbed above 7% for the first time since May 2024. Rates fell to as low as almost 6% in September of last year before this surge.

In December, the Federal Reserve (the “Fed”) lowered the federal funds rate for the third time, bringing its target policy range down 100 basis points (or 1%) from 5.25%-5.50% to 4.25%-4.50%. Following the 0.25% interest rate cut at the December Fed meeting, Federal Reserve Chairman Jerome Powell made the following comments, which cast some doubt to markets over the Fed’s future rate-cutting path:

“Today was a closer call, but we decided it was the right call. From here, it’s a new phase, and we’re going to be cautious about further cuts.”

The Federal Reserve’s 1% interest rate cut, at what we in the industry call “the short end of the yield curve,” provided some immediate relief to consumers with credit-card balances and those with shorter-term variable-rate debt, such as small businesses. However, longer-term rates on loans such as mortgages, auto loans, and corporate debt have sharply risen in recent months.

What is the Federal Funds Rate and How Does the Federal Reserve Control It?
The Federal Reserve (the Fed) controls a specific interest rate called the "federal funds rate." This is the rate at which banks lend money to each other overnight. It's a very short-term rate, usually for just one night. When the Fed cuts this rate, it makes borrowing cheaper for banks. In turn, banks can offer lower interest rates on things like credit cards, car loans, and other short-term loans.

It’s important to understand, however, that long-term mortgage rates are not directly tied to what the Federal Reserve is doing and are rather driven by investor expectations and market conditions. As the financial system exists today, the Federal Reserve cannot just direct banks to charge certain rates on long-term loans. Rather, long-term rates are impacted by several factors including, but not limited to:

Inflation and Inflation Expectations
Economic Growth
Government Deficit Levels
Supply and Demand
Global Economic Conditions

Mortgage rates tend to move more closely with longer-term government bond yields. In other words, the rate the government pays on the debt it issues over longer maturity ranges, such as the 10-year. 10-year government Treasury rates have been on the rise in recent weeks. Uncertainty over inflation and whether it is truly under control, as well as the persistently high single-digit percentage federal budget deficits, are some of the factors playing into the upward drift in mortgage rates. Inflation has come down significantly, but the data occasionally signals to market participants that it may not be fully under control. Any signs of inflation re-accelerating could mean that the Fed might be more cautious in cutting rates further or, even worse, that they would have to reverse course and raise rates again to cool off the economy.

Speaking of the economy, it has been extremely resilient and strong in the face of the significant inflation we saw over the past few years. Economic strength affords the Fed time to wait longer to cut interest rates. A stronger economy means more money in the pockets of consumers chasing goods and services, which could contribute to higher inflation.

Now that I have given you a lesson on how the Fed affects rates, let’s turn our attention back to how this is dampening home-buyer demand. The combination of 7% rates, along with inflation in categories such as property insurance and real estate taxes, has created a dynamic where home affordability has significantly decreased. While 7% seems very high compared to the mid 2% interest rate levels we briefly saw in 2021, its important to remember that mortgage rates were in the 6 to 7% range in the 1990s and early 2000s and were even in the double digits during the 1970s and 1980s.

But that history lesson still doesn’t put buyers at ease, as we have been spoiled by the zero-interest rate policy world with ultra-low inflation that we lived in for more than a decade after the Global Financial Crisis.

As the Wall Street Journal reported, sales of previously owned homes in 2024 likely fell to the lowest level since 1995, for the second year in a row. If rates remain elevated into April, this could challenge realtors during the spring selling season, which is usually an extremely active time for sales.

According to John Burns Research & Consulting, which conducts various consumer studies and surveys, the "magic mortgage rate" that would truly unlock and improve the real estate market is below 5.50%.

Potential sellers, who got mortgages prior to the Fed rate hiking cycle in 2022 (not me, unfortunately), have extremely low interest rates. There are plenty of memes out there that you may have seen on social media about these potential sellers that are faced with a conundrum. Why would you give up a 2.5 to 4% interest rate to buy a more expensive house at a 7% mortgage rate unless you absolutely must? This dynamic has been keeping supply down overall. Having said that, there are some sellers who will eventually reach a breaking point and decide they can’t wait any longer for rates to fall. It will be interesting to see what the Spring season has in store for us.

Are you in the real estate business or a buyer/seller that has been impacted by the dynamics mentioned in this article. Would love to hear your thoughts and experiences!

Sources:

Freddie Mac: Mortgage Rates

Wall Street Journal: Mortgage Rates Top 7% for First Time Since Mid-2024

Wall Street Journal: Fed Signals Plan to Slow Rate Cuts, Sending Stocks Lower

NPR: Fed cuts were supposed to lower mortgage rates, but they're back above 7%. Here's why

ResiClub: The housing market's 'magic mortgage rate' is proving elusive