Are you asking yourself whether you should buy a home in a rising interest rate environment? The Federal Reserve telegraphed they will start tapering by the end of 2021, which means that bond yields may start rising.
Further, the Fed Funds rate is currently at 0% – 0.25%, and is likely to be raised multiple times over the coming years. Many indicators are signaling that inflation is rising after trillions of dollars of stimulus has been unleashed. Hiking interest rates is one of the main ways to combat inflation.
Rising interest rates is usually a headwind for the real estate market. It makes makes mortgage borrowing costs higher. At the same time, rising interest rates also tend to happen when the economy is heating up.
Therefore, the question is whether a stronger economy or rising interest rates has the most impact on housing prices.
* You'll learn why a rising Fed Funds rate doesn't necessarily mean rising mortgage rates.
* The main determinants of buying a home.
* Where we are in the property market cycle.
* You can always refinance. You can never change the purchase price of your home.
The Interest Rate Market
As soon as the Fed starts raising rates, brokers and real estate pundits in the media tend to say, “Buy now before it's too late!” There's nothing like a little Fear Of Missing Out to get people to make big decisions without thoroughly thinking things through.
The instant response everybody should have when fed this line is: Don't higher interest rates make homes less affordable at the margin? If homes are less affordable, doesn't that hurt property demand? And if demand for property declines, doesn't that mean prices might go down instead?
Whenever you are talking to someone whose main source of income is through transactions, be a little suspicious. After all, from a real estate broker's point of view, it's always a good time to buy or sell!
We've already discovered how to invest and potentially profit in the stock market when rates rise. Now it's time to explore whether to buy a home in a rising interest rate environment.
My hope is that this post educates future homebuyers, reduces the number of future debt flakers, and creates a stronger America as a result! When you buy a home, you have got a lot to think about.
Understanding The Fed Funds Rate
To first understand whether to buy a home in a rising interest rate environment, it's important to understand the Fed Funds Rate (FFR).
The Federal Reserve controls the Federal Funds rate, the interest rate everybody is referring to when discussing rising rates. The Federal Funds rate is the interest rate in which banks lend to each other, not to you or me.
There's generally a minimum reserve requirement ratio a bank must keep with the Federal Reserve or in the vaults of their bank, e.g. 10% of all deposits must be held in reserves.
Banks need a minimum amount in reserves to operate, much like how we need a minimum amount in our checking accounts to pay our bills. At the same time, banks are looking to profit by lending out as much money as possible at a spread.
If a bank has a surplus over their minimum reserve requirement ratio, they can lend money at the effective Federal Funds rate to other banks with a deficit and vice versa.
You can see how an effective Fed Funds rate of only 0% – 0.25% would induce a lot more inter-bank borrowing in order to re-lend to consumers and businesses, and keep the economy liquid.
This is exactly what the Federal Reserve hoped for once they started lowering interest rates in September 2007 as home prices began to collapse.
Study the Fed Funds Rate charts below.
Federal Reserve Combatting Recessions
By the summer of 2008, everybody was freaking out because Bear Sterns was sold for a pittance to JP Morgan Chase. And then on September 15, 2008, Lehman Brothers filed for bankruptcy. Nobody expected the government to let Lehman go under, and that's when the panic really began.
What happens when everybody freaks out? Banks stop lending and people stop borrowing! This is called “a crisis of confidence.” The Federal Reserve lowered the Federal Funds rate in order to compel banks to keep funds flowing. Think of the Federal Reserve as keeping the oil flowing through a dying car engine.
It's been years since the Federal Reserve lowered the Fed Funds rate to 0.15%, and since January 2009 the stock market is up more than 220%; the housing market has recovered with some markets like San Francisco blowing past its 2007 peak by 30%, and unemployment has dropped to 4.1% in 2018 from a high of 9.9% in March 2010. What does this all mean?
Well, the global pandemic happened. The Federal Reserve slashed rates in 2020 again. Now, we are in a wait and see mode for employment to come back. However, it sure seems like everybody wants to buy a home today.
The Federal Reserve's main goals are to keep inflation under control while keeping the unemployment rate as close to the natural rate of employment (full employment) as possible.
The Federal Reserve does this through monetary policy – raising and lowering interest rates, printing money, or buying bonds. They've done a commendable job since the financial crisis, but inflationary pressure is an inevitability.
Why is inflation bad? Inflation isn't bad if it runs at a foreseeable 1-3% annual clip. It's when inflation starts going at 5%, 10%, 50%, 100% where things get out of control because you might not make enough to afford future goods, or your savings and investments are losing purchasing power at too fast a pace, or you simply can't plan your financial future.
The only people who like inflation are those who own real assets that inflate along with inflation, e.g. real estate. Remember to always try and convert funny money into real assets! Everybody else is a price taker who gets squeezed by higher rents, higher tuition, higher food, higher transportation and so forth.
The Federal Reserve needs to raise interest rates before inflation gets out of control. By the time inflation is smacking us in the face, it will be too late for the Fed to be effective since there's a lag in monetary policy efficacy.
Higher interest rates slow down the demand to borrow money, which in turns slows down the pace of production, job growth and investing. The rate of inflation will eventually decline as a result.
If the Federal Reserve could engineer a 2% inflation figure and a 5% unemployment figure forever, they'd take it!
How Does The Fed Funds Rate Affect Mortgage Rates For Homebuyers?
The Federal Reserve determines the Fed Funds rate. The MARKET determines the 10-year yield. And most importantly, the 10-year Treasury yield is the predominant factor in determining mortgage rates.
There is definitely a correlation between the short duration Fed Funds rate, and the longer duration 10-year yield as you can see in the chart below.
Study this chart very carefully, as it will tell you a lot about whether you should buy or sell a home in a rising interest rate environment.
The first thing you'll notice is that the Fed Funds rate (red) and the 10-year Treasury yield (blue) have been declining for the past 30+ years. There have definitely been times where both rates have spiked higher between 2% – 4% within a five-year window. However, the strong trend is down due to knowledge, productivity, coordination, and technology.
What else can we learn from this chart?
1) The Fed probably won't raise the Fed Funds rate by more than 4%, or even come close to a 4% increase. From 1987 – 1988, the Fed raised rates from 6% to 10%. From 1994 to 1996, the Fed raised rates from 3% to 6%. From 2004 to 2007, the Fed raised rates from 1.5% to 5%.
2) The longest interest rate upcycle is about three years once the Fed starts raising rates. We now know that 4% and three years are the backstop for a rising interest rate environment.
3) The 10-year yield doesn't fall or rise by as much as the Fed Funds rate. In other words, you probably don't have to fear a large interest rate reset if your ARM mortgage expires. In fact, anybody taking an ARM mortgage over the past 30 years has seen their interest rates fall. Owning a 30-year fixed mortgage is a more expensive route.
4) The S&P 500 has generally moved up and to the right since its beginning. The steepening ascent corresponds to the drop in both interest rates since the 1980s. The S&P 500 can be a representation of housing prices across the country.
5) The current difference (spread) between the Fed Funds rate and the 10-year yield has been over 2% for the past seven years, which provides a significant buffer for the Fed to raise Fed Funds while the 10 Year Treasury yield can still stay the same.
Take a look at what happened between 2004 and 2010. The spread between the 10-year yield and Fed Funds rate was around 2%, just like it is now. The Fed then raised the Fed Funds rate to 5% from 1.5% until they burst the housing bubble that they helped create! The Fed Funds rate and the 10-year yield reached parity at 5%, instead of the 10-year yield maintaining its 2% spread and rising to 7%.
Important Point About The FFR
The Fed can raise the Fed Funds rate, and the 10-year yield may not even budge higher given the spread is about 1%.
Below is a closeup chart of the S&P 500, the Fed Funds rate, and the 10-year bond yield.
The Market Is Efficient And Knows Best
Now that you've got a great understanding of interest rates, you can see how vacuous a statement it is when someone tells you to buy property before interest rates go up. If anybody says this to you, they are either ignorant or do NOT have your best interest at heart.
The Fed Funds rate could easily go back to 2% over the next three years. Meanwhile, the 10-year yield might very well stay below that range. Or it may at most maintain a 2% spread during the same period. Remember, the markets determine the 10-year bond yield, and we've so far just discussed domestic demand.
China, India, Japan, Europe are all huge buyers of US government bonds as well. Let's say China, Japan, Brazil, Switzerland, and Greece all go through hard landing scenarios. International investors will sell Chinese, Japanese, Brazilian, Swiss, and Greek assets/currency, and BUY US government bonds for safety. The USD is, after all, the world currency. If this happens, Treasury bond values go UP, while bond yields go down.
The US has foreigners hooked on our debt because US consumers are hooked on international goods, most notably from China. The more the US buys from China, the more US dollars China needs to recycle back into US Treasury bonds.
China certainly doesn't want interest rates to rise in the US. If they do, their massive Treasury bond position will take a hit, and US consumers will spend less on Chinese products at the margin!
Thank goodness we're all in this together, just like during the global pandemic!
The Main Determinants Of Buying A House
Rising interest rates are generally a result of a robust economy. A robust economy is by far the most important determinant of housing prices.
If the unemployment level is declining, people in your city are getting raises, and expectations for continued growth are there, housing prices will continue to go up, despite rising rates.
The issue the Fed has is getting the TIMING of their monetary policy right to contain inflation and engender maximum employment.
I recommend everybody be at least neutral the property market by owning their primary residence. Being neutral the property market means you are no longer a victim of inflation given your costs are mostly fixed.
You can't really profit from the real estate market, unless you sell your house and downsize. You don't really lose either, so long as you can afford the house, since you've got to live somewhere.
Before going neutral the property market, it's important to have the confidence that you'll own your house for at least five years, if not at least 10 years.
Hold Onto Your Property For The Long Term
I never go into a property purchase thinking I'll sell within 10 years. In fact, I always have the mindset that I plan to buy and own forever since I buy property for lifestyle purposes first.
The only way you can gain confidence of owning your property for 10 or more years is if you are:
- Bullish about your employer's growth prospects
- Positive about your own career growth and talents
- Have 30% or more of the value of your property saved up in cash or liquid securities (e.g. 20% down, 10% buffer at least)
- Love the area and can see yourself living there forever
- You've got rich parents, relatives, or a trust fund to bail you out
If you're taking out a PMI mortgage because you've got less than 20% down, it's understandable why you'd be scared buying property. You can't afford it! In the old days, most people would simply pay all cash!
Property Market Forecast
I'm bullish on real estate for the next few years. I believe mortgage rates will stay low for the rest of the decade. The intrinsic value of real estate has also gone up because we're spending much more time at home. Therefore, you want to buy a home not rent.
Everybody wants larger properties with more more space. As a result, expect to see an aggressive move up market. Further, we should see an aggressively move out market from small rental properties to first-time homes. Buy a home to make money and live a great life.
Despite the global pandemic, the S&P 500 closed up 16%+ in 2020. The NASDAQ closed up a whopping 40%. In 2021, stocks are up even more. Some of these stock market gains will flow to real estate. At the very least, I would get neutral real estate by owning your own home.
In addition to buying rental properties, I'm also investing in real estate crowdfunding to buy real estate in the heartland. Valuations are much cheaper in the heartland of America (~10X annual gross rent vs 20 – 30X annual gross rent in coastal cities). Net rental yields are also much higher as well (8% – 15% vs. 2% – 4% in coastal cities).
If I can earn a 9 – 12% returns on my crowdfunding investment, I will equal my cash flow from my $2.74M house that I sold with $2.24M less in exposure.
My Two Favorite Real Estate Crowdfunding Platforms
Fundrise: A way for accredited and non-accredited investors to diversify into real estate through private eFunds. Fundrise has been around since 2012 and has consistently generated steady returns, no matter what the stock market is doing.
CrowdStreet: A way for accredited investors to invest in individual real estate opportunities mostly in 18-hour cities. 18-hour cities are secondary cities with lower valuations, higher rental yields, and potentially higher growth due to job growth and demographic trends.
Both platforms are free to sign up and explore.
When interest rates are rising, it's general a good signal for real estate as the overall economy gets stronger. The key is to take advantage when mortgage rates are low.
Refinance Your Mortgage Today
In addition to investing in real estate, please refinance your mortgage today if you are a homeowner. You can do so by checking out the latest rates with Credible. Credible has qualified lenders competing for your business so you can get the lowest mortgage rate possible for refinance or purchase.
Take advantage of all-time low mortgage rates today before they start going up again. Buy a home, enjoy it, and get wealthier in the long-run.