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How Does the Federal Funds Rate Affect Real Estate?
January 5, 2008
You hear it on the news all the time. Will the Fed lower rates? Will the Fed raise rates? The most important question of all, of course, is: how does it affect me?
A little background is in order. The Federal Reserve is the central banking system of the United States, and as such acts to preserve the stability of the monetary system. In other words, it has two primary and somewhat conflicting goals: keep inflation to a minimum, and maintain economic growth. In order to do this, it has several weapons at its disposal. It can directly buy or sell government securities such U.S. Treasury bills and savings bonds, thus directly creating or taking money out of circulation. It can change the required reserve rate of United States banks. Most famously, it can change the federal funds rate.
The federal funds rate, in a nutshell, is the interest banks must pay to borrow money from each other. A common misconception is that banks take the money that people put in their savings accounts and lends it out to other people. In actuality, a bank can lend out up to ten times as much money as it owns! (1) Daily fluctuations, as people deposit and withdraw money, lead to some banks having more money than they need on hand, and other banks not having enough. There’s a market for this, where banks lend each other money overnight. It’s a capitalist system; banks bid and offer different amounts of interest to borrow money. The federal funds rate is the target rate for this overnight lending. The Federal Reserve attempts to influence the rate by becoming a buyer or seller itself; it cannot just dictate what the rate will be.
Why does this all matter? It’s a very broad way for the Federal Reserve to influence the economy. The cheaper it is for banks to borrow money, the cheaper they can loan it to borrowers themselves. If they are paying 5.25% (the current target federal funds rate) to borrow money, you had better believe they are not going to loan it out to people for 5%. They’d be losing money on every loan they made! Instead, they charge a little bit for you to borrow it, and that’s how banks make money. As the old joke goes, banking is a 3-6-3 job… borrow at 3%, lend at 6%, then get to the golf course by 3 o’clock.
Now suppose you are looking to buy a house for $200,000, putting 20% ($40,000) down. You can get a simple 30-year fixed mortgage for the remaining $160,000 at 6.23% for $983.07/month. Now let’s assume that the Fed thinks that the economy is growing too quickly, and suddenly raises the fed funds rate by one percentage point. Banks, who were used to borrowing money at 5.25%, are now borrowing at 6.25%. Again, they’re not going to loan you money at 6.23% since they would lose money with every loan they made. They’ll eventually be forced to start loaning at, say, 7.25%. If you got the same mortgage terms as before, you’d be paying $1091.48/month – an increase of over a hundred dollars per month! Since most homebuyers tend to look at their monthly payment instead of at the entire purchase price of the house, they’re going to be more hesitant to buy that house, or they won’t want to pay as much. In order to pay the same amount per month as before, they would need to knock about $15,000 off the purchase price of the house. In the long run, the price of real estate would tend to stabilize or drop. More likely than not, it would stabilize, since for expensive items such as real estate, sellers tend not to drop their price rapidly, but prefer to let the “real” price (what others are offering) catch up to their selling price.
On the other hand, if the Fed wanted to help the economy grow more quickly, they could lower the rate by a percentage point to 4.25% and that mortgage’s monthly payments would now be $883.53. People would be able to afford more house for the same amount of money, and the prices of real estate would increase. People would be more inclined to borrow money to buy property, and more houses would be built and bought by people seeing the prices of houses increasing rapidly. This would also cause many secondary effects, such as creating an increased demand for lumber, brick, and other building materials.
Of course, the federal funds rate is only one factor in determining the prices of real estate. The location of the property, the time of year, whether or not the house has furniture in it, and a thousand other variables all combine to create the selling price of the house. All that said, knowing how the federal funds rate affects your real estate holdings is an important piece of the pricing puzzle.
(1) The current Federal Reserve-mandated reserve rate is 10%, meaning that the bank needs to maintain hard currency equal to 10% of its outstanding loans. As noted above, the bank varies this rate in order to help either precipitate or slow down economic growth, although this is rarer now than in the past.
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