Interest rate behavior

We all know that now is the time to buy real estate with interest rates so low. The Federal Reserve has maintained that they will keep rates low until they feel the economy is fully recovered. Even with home prices in our Texas metros near an all time high, there will not a more affordable time to buy.

Will rates go up?
As we have stated before, eventually, yes! In the short term, no. According to most experts and the Federal Reserve, they should stay low through 2013 and possibly longer. There are many factors involved. Also know that over a year ago, in this same forum, I and others felt that mortgage rates would be over 5% by the end of 2012.

Historically this is the longest we have seen rates stay this low. Please understand that the Federal Reserve has kept rates low for a reason. By law, the Federal Reserve’s monetary policy is to achieve maximum employment, stable prices, and moderate long-term interest rates.

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The Great Recession and the worldwide financial crisis that started in early 2007 and ended late in 2009 has been one of the most intense periods of national and global financial strain since the Great Depression, and it led to a deep and prolonged global economic downturn affecting almost every developed country. Europe and many countries are still struggling with the after effects of the recession.
Thankfully, the Federal Reserve, our central bank, took some extraordinary steps in response to the financial crisis to help stabilize the U.S. economy and financial system. For those of you that don’t remember, these actions included reducing short-term interest rates from the central banks (the money the Fed lends to all member banks) to near zero, in the hopes of reducing longer-term interest rates and to reduce the cost of borrowing to provide support for the U.S. economy. These lower interest rates help consumers and businesses finance new spending and investing that in turn help support the prices of many other assets, such as stocks and houses.

Quantitative easing
To further encourage the economy, the Federal Reserve has purchased large quantities of long-term Treasury securities in a strategy dubbed “quantitative easing”. The overall planned financial effect is to force lenders and equity to put their money into higher risk, higher return investments, rather than bank CDs. Slowly, the economy has begun recovering, but progress towards the stated goal of maximum employment has been slow and the unemployment rate remains high compared to historic norms. The good news is that despite rock-bottom interest rates, inflation has remained low, apart from some temporary variations associated with fluctuations in prices of energy and other commodities. Also the low lending rates have created an opportunity for buyers (consumers and business) to invest in real estate and other goods, improving the national economy.

Understand that historically, mortgage interest rates have been anything but stable: one day they would fall – the next they would rise. The only thing that was certain was that they rarely remain the same for long periods of time. Someone in the market to buy a home would keep a close eye on rates. But just what is it that causes mortgage interest rates to fluctuate so often? There are many factors involved. But I assure you, they have stayed low for an abnormal length of time. It is time for the economy to heal and with that rates will have to rise.

When interest rates change, it is the result of many complex factors. Those who study interest rates find that it is as difficult to forecast future interest rates as it is to forecast the weather. Since interest rates reflect human activity, a long-term forecast is virtually impossible. After a rise or fall in interest rates, analysts may sound confident about what caused the variation – but any truthful economist, banker, or analyst will tell you they can’t predict rates 5-10 years from now.

Some of the factors that help to dictate interest rates are explained below.

Interest rate behavior

By this time we all know that a slowing economy is good news for borrowers, as it means lower interest rates. If the demand for borrowing capital recedes, then so do interest rates. This is because there are more people who are ready to lend (sellers) than people who want to borrow (buyers). This means that buyers can command a lower price, i.e. lower interest rates. When the economy is slowing the demand for credit decreases, and interest rates go down. Now the unusual thing is that demand has picked up over the last 12 months and rates have not increased. This is because of the artificial low interest rate the Federal Reserve has imposed.

A growing economy is bad news for borrowers because it force up interest rates. When there is a greater demand for credit / money, it forces rates up. Interest rates move because of the laws of supply and demand. If the demand for credit (loans) increases, so do interest rates. This is because there are more people who want money (buyers) than there are people willing to lend it, so those lenders can command a better price; ie, higher interest rates. When the economy is expanding there is a higher demand for credit, so interest rates go up.

Interest rates are the price for borrowing money. Interest rates move up and down, reflecting many factors. The most important among these is the supply of funds, availability and parameters for loans from lenders, and the demand from borrowers. In addition, to keep our banks liquid regulators force certain parameters on the lenders which effect how much a consumer has to put down or have in reserve to qualify.

Take the mortgage and lending market for example. In a period when consumers are borrowing money to buy homes, banks and equity need to have the funds available to lend. They get these from their own depositors. The banks will pay 6% interest on certain financial instruments, and then charge 8% interest on a five year mortgage. That is how they make money. If the demand for borrowing is higher than the funds they have available, they then borrow money from other groups by issuing bonds to institutions in the “wholesale market”. This source of funds is always more expensive. When banks and equity have lots of money to lend and the housing market and demand for capital is slow, any borrower financing a house or purchase gets a lower rate, and in a free market, most lenders will be very competitive, keeping rates low.

Realize that money is perfectly liquid and because of that it is converted easily. In particular, when the demand for money rises, so do interest rates – the “price” of borrowing money. There are many economic drivers that can increase demand – rising consumer spending, the belief that costs for buying and selling will increase, the expectation of a stronger dollar in the near future, increased demand for reserves from central banks (both foreign and domestic), and a rise in foreign demand for US goods and investments. With this demand, there is less desire for the lower return on current bonds. With this greater demand for money, the central banks can charge more. So, each of these aspects pushes up the demand for US dollars, while the reverse decreases the demand for dollars. A rising demand for money, with all else constant, will raise interest rates while the opposite is also true. The opposite can also happen during times when the market becomes averse to riskier assets because investors will move into the dollar and U.S. debt in a search for safety. The demand for money, combined with the supply of money determine interest rates. Since currency is the most liquid store of value, its demand demonstrates the demand, or preference, for liquidity.

Low rates will not be permanent. The only group buying treasury bonds is the Federal Reserve. The demand for lending is picking up at most of the major banks according to a national survey of CFOs and loan officers by the Federal Reserve, and most are planning to hire as well as lend in 2013, leading to expansion. More demand on money forces rates to go up. Mortgage and housing is just one component.

For the non-finance majors out there, this happens in the fixed income markets as a whole. In a booming economy, many firms borrow funds to expand their companies, finance inventories, and even acquire other firms. With rates so low, many have held their own capital earnings, rather than invest. The return for earning for many is better than the cost of borrowing. Meanwhile, consumers look to buying cars, houses and other needs and begin to entertain more. This keeps the “demand for capital” at a high level, and interest rates higher than they otherwise might be.

The interest rates charged by banks are influenced heavily by the decisions and actions of the Federal Reserve. The Federal Reserve, known as the “Fed”, can manipulate interest rates by buying and selling bonds in the bond markets. During economic times when the Fed wants to stimulate the market, the Fed buys bonds on the open market and pays for the bonds with cash. If the Fed continues to buy bonds, the market becomes flooded with cash. This excess cash in turn makes money more available for people who want to borrow. The result is interest rates will naturally come down as different lenders compete for a limited pool of borrowers.

The effect of interest rates on consumers is well known. For every 1% rise in rates, consumers can buy 12% less. Values across the country have improved. Here in Texas they are near highs in all of our major metros. So if you don’t buy today, whether it is from increased home values or eventually higher borrowing costs, you will pay more.

As consumer confidence grows people start spending money. What do they buy? Everything under the sun, but consumer goods is the term you will hear most often. People buy cars, computers, and appliances. As demand for products increase, companies can begin to charge more for their products. As companies begin to make more profits it is not long before workers begin asking for more benefits and more money in their paychecks. As companies meet worker demands, the company experiences increased costs and expenses then inflation begins.

In the last sixty years there has not a better time to purchase a home. You will never be able to afford to buy as much house as you can today! Plain and simple. Draw all the charts and graphs you want. The fact still is: Now is the time to buy! If not now, when?

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