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Interest Rates and the Fed

How the Fed Influences the Real Estate Market

The Federal Reserve (the Fed) was created to control the money supply for the United States. However, over time, the Fed has also acquired the task of maintaining an national unemployment rate of around 5% or less while keeping inflation as low as possible. As you might imagine, this is a very daunting responsibility. Except for a major pothole in their road (do you remember the late 1970s?), the Fed has done remarkably well at achieving these lofty goals.

Interest rates are their primary weapons to achieve these targets. While they do not directly set or influence mortgage loan rates, their actions indirectly have an enormous affect on mortgage and bank interest rates. This directly influences the real estate market - for better or worse. Here's why.

Interest rates are one of the three major components of the real estate market. The other two factors are the availability of willing buyers and the number of homes for sale. A good balance of the number of buyers and homes for sale typically bodes well for a good or, at least, stable housing market. However, this stability is totally dependent on the availability of mortgage loan financing at affordable rates. Notice the term "affordable". This does not imply very low interest rates, only that mortgage and bank interest rates are reasonable for the market. Actually, very low interest rates, such as those in the U.S. in the past decade sometimes "overheat" the real estate market, driving FMVs (fair market values) much higher than can be sustained long-term.

The Fed uses two primary rates to control all others:

  1. The "Discount" Rate. This is the rate banks pay when they borrow directly from a Federal Reserve Bank for "overnight loans" that help their cash and liquidity positions and requirements. You won't be surprised to learn that when banks pay more for their money, consumers will also pay more for loans.
  2. The "Fed Funds" Rate. This is the rate banks charge each other for "overnight loan" borrowing. Why do banks need to borrow from other banks, you ask? Banks are required to keep a specified cash reserve level at all times. On heavy loan disbursement or withdrawal days, they may drop below their required cash level. Other banks may have low cash outflows and have excess funds. They then loan money to the banks in need. While the Fed does not directly set the Fed Funds rate, they strongly influence its level.

As these two rates rise, banks and other lenders increase their "prime rate" (available to the most credit worthy borrowers), consumer loan rates (personal, auto, home equity, etc.), and mortgage rates. Increasing or decreasing mortgage loan rates influences both domestic AND international real estate market activity (as other countries are influenced by U.S. rates).

Therefore, although the Fed has no direct responsibility for mortgage loan rates or real estate, they strongly influence influence the market, including both commercial buildings and homes for sale .


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