When Will Mortgage Rates Go Up?

Over the last several months, I've written a lot about the current state of residential real estate, and the opportunities made available by the combination of lower housing prices and falling interest rates. As we approach the end of this year's residential real estate buying-and-selling season, this is a good time to start thinking about what might lie ahead.

While plenty of drivers affect the housing market, there may be none more important than how the Federal Reserve handles interest rates. All things being equal, the lower the interest rates charged by the Federal Reserve, the lower the mortgage rate you will be able to get when it comes time to buy (or refinance) your home.

Before we talk about what the Fed will do next, let's step back to put everything in perspective.

When the economy—and the real estate market—tumbled in 2008, the Fed stepped in to lower interest rates. As we have seen throughout history, lower interest rates makes housing more affordable, increase the likelihood of transactions, and ultimately produce stabilization in the residential real estate market. A major clue to where the residential real estate market is headed lies in the question of where interest rates might be headed.

Mortgage rates: near historic lows

Start by looking at the federal funds rate, which is what banks charge each other for borrowing funds overnight. In December of 2007, the federal funds rate was approximately 4%. The federal government was selling 10-Year Treasury notes at around 4.5% while the 30-year-fixed mortgage rate averaged 6.17%. Between the fourth quarter of 2008 and January of 2009, the Fed announced it planned to drop the fed funds rate to between 0% and 0.25%, essentially allowing banks to be able to borrow from one another at virtually no cost. That's where it has remained.

As a result, interest rates on 10-Year Treasury notes have been driven down to 3.8%, and the average 30-year-fixed rate mortgage is now 4.9% nationwide.

So where do we go from here?

As I wrote in earlier articles, mortgage rates are near historic lows. The Fed's stated policy to lower interest rates has thus been successful. Rates fell dramatically.

Clues to a Fed course reversal?

But when will the Fed begin raising rates to keep inflation at bay? Put another way, what signs should signal an impending change in the Federal Reserve's policy on interest rates? The Fed has been very transparent about its direction. And it announced recently that it has no intention of raising rates soon. The minutes from the Federal Open Market Committee on September 22 and 23 clearly state a short-term intention to keep rates low: "no policy change." They also indicate that while the Fed believes "an economic recovery is underway," a weak economy is regarded as a greater risk than inflation.

We can be sure the Fed will tell us in forthcoming meeting minutes about their intent to raise rates. But if past is prologue, long-term rates are likely to go up in advance of any formal announcement. We need to look for clues as to when a rate hike might be coming.

There are many indicators. But some, such as real gross domestic product, can be complicated and are often more revealing when we put them in context by comparing them with other variables.

Look for a rising discount rate

A relatively straightforward clue to monitor closely is the unemployment rate, which tracks the percentage of Americans out of work. That number stood at 9.7% recently. If it starts to come down in earnest, we'll have a good indication that the Fed may begin raising rates.

Another indicator to keep an eye on is the discount rate, which is the interest rate the Fed charges banks that borrow from it directly. Currently it stands at 0.5%. If it starts to climb—or if the spread between it and the Federal Funds rate begins to widen—it's a solid sign that interest rates (and therefore mortgage rates) will rise.

You and I aren't the only ones doing the watching. If you see the 30-year mortgage rate start to climb relative to other interest rates, it's a sure indication that your friendly neighborhood mortgage broker thinks a Fed rate hike is on its way—and that mortgages rates will climb.

So if you are thinking of buying or refinancing a home, this is a pretty good time to move, before rates begin to rise again.

Manipulating short-term interest rates is not the only way the federal government influences the housing market. In my next column I'll discuss the Fed's policy on purchasing mortgage backed securities—which gives it a powerful tool to manipulate long term rates—as well as the first-time home buyer's tax credit.

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