How Inflation Affects Mortgage Interest Rates

Even people that don’t pay very close attention to broad economic trends taking place across the country can’t help but notice that the past few months have seen some big shifts. The housing market hit historic highs and interest rates for new mortgages were at historic lows for a very long time. But, reports of rising inflation and a potential recession started splashing across headlines everywhere in late 2021, and they have begun to have a very real impact on individuals hoping to finance a home. 

Many prospective homebuyers are now wondering what exactly inflation is, how it’s connected to mortgage interest rates, and how it will affect their homebuying experience.

What is Economic Inflation?

In short, inflationary periods are those in which the price of goods and services steadily rise, meaning the same amount of money buys fewer goods and services today than it did in the same period a year ago. 

The annual inflation rate in the U.S. hit 8.5% in 2022, the highest it’s been in over 40 years. According to Freddie Mac, the average mortgage interest rate for a 30-year fixed-rate loan rose to 5% in April, which is a ten year high. Higher mortgage interest rates aren’t directly caused by higher inflation, but there is a clear correlation and most economic experts caution that inflationary pressures almost always indirectly lead to higher interest rates.

When inflation devalues the U.S. dollar, buyers have less purchasing power, which in turn limits their options when shopping for a home. Furthermore, as inflation rises and economies cool, demand for financial products that support the mortgage industry, specifically mortgage-backed securities (MBS), drops. 

MBS are bundles of mortgages that are packaged together, securitized, and sold on the open market. Many of those MBS are sold by Fannie Mae and Freddie Mac, government-sponsored enterprises that exist specifically to enhance liquidity in the housing market. But, when there are fewer investors buying America’s mortgages, interest rates for mortgage-backed securities generally increase to attract new buyers and compete against government-backed securities like treasury bills.

With global supply chain issues still limiting access to the materials necessary for the construction of new homes, the supply of new homes to purchase remains insufficient to meet the market’s demand — despite interest rates and inflation rising and housing prices that are still very high historically. However, if rates and inflation continue to increase, economists warn there could be a slowdown in housing.

What Determines a Homebuyer’s Interest Rate?

How much a buyer can expect to pay in interest for a home mortgage comes down to many factors:

• Credit Score
• Term Length (short loans typically have lower rates)
• Down Payment Size
• Debt-to-Income Ratio

Buyers can increase their attractiveness to lenders by optimizing for those criteria, but there are other factors that affect interest rates that are out of their control, and inflation is a big one. Right now, inflationary pressures are unfortunately coming from both the supply side and demand side of the marketplace. 

Supply side inflation occurs when a lack of supply for goods and services drives up prices, which occurred as a result of the lockdowns and supply chain disruptions associated with the pandemic. Demand side inflation refers to price increases linked to rising demand. 

During the pandemic, there was a mad rush by many to move out of apartments and into single-family homes (and out of smaller houses into larger ones). That trend pushed housing prices to all-time highs, with the median sales price of existing U.S. homes topping $357,000 by the start of 2022. What happens in one sector of the economy can have ripple effects that are felt by all others. Rising costs in housing led to rising costs elsewhere and vice versa.

What Role Does the Federal Reserve Play in Mortgage Rates?

The Federal Reserve, often called simply the Fed, is the central banker of the United States. Its job is to control inflation and unemployment figures with monetary policy. The Fed cannot directly change mortgage interest rates. What it can do is recommend changes to the federal funds rate (the interest rate that banks charge each other to move money overnight). Other financial sectors in the economy closely watch what the Fed does with the federal funds rate, and when the Fed calls for an increase, other lenders often follow suit.

In May of 2022, the Fed raised rates by 0.5% and the following month it agreed to another 0.75% rate increase. Raising interest rates is the Fed’s most powerful weapon against runaway inflation and it has indicated that it will continue to raise rates until inflation comes back under control.

What Can Homebuyers Do About Rising Inflation?

With prices spiking and wages mostly stagnant across the country, families everywhere are concerned about their ability to afford basic goods and services — and many homebuyers are worried that they will be saddled with a high interest rate if they look for a mortgage in this market. 

Mortgage shoppers can respond to these issues at least partially by reducing their outstanding debts and choosing a fixed-rate mortgage. Some lenders also offer mortgage rate locks, so the rate a buyer is offered after preapproval will remain in place so long as they close on the home within a specified time (often around six weeks).

Finally, it’s helpful to keep in mind that even after several increases, mortgage rates are still very low historically and there are excellent opportunities still available for securing a low interest rate loan, or to refinance an adjustable-rate mortgage to a fixed rate before interest rates rise further.

FSB Mortgage is a nationwide, bank-backed lender offering a broad range of loan products to retail customers. Get in touch today to learn about our flexible lending products, fast turn times, and exceptional customer support.