How do higher mortgage rates help reduce inflation? Here is an explainer.

The Federal Reserve this week hiked a short-term interest rate, making it more expensive to borrow money to buy or repair a home.

The central bank hiked the federal funds rate by 0.5%, or half a percentage point, last week. The Fed had not raised the federal funds rate by half a percentage point at a meeting since 2000.

The 0.5% hike is viewed as a “hawkish” or aggressively anti-inflationary move. Prominent Fed officials had been hinting for weeks that they would hike rates more than usual, and mortgage rates had already risen sharply in anticipation of this and had increased by around three-quarters of a percentage point from mid-March to the end of April.

“The talk for the past few weeks has all been about a much more hawkish stance, and that’s where this hike in interest rates took place,” said Selma Hepp, deputy chief economist at CoreLogic, a provider of real estate information and analytics.

Read: ‘Pandemic boom in home sales is over’: Mortgage rates rise to highest since 2009 as Fed squeezes housing market

The Fed’s Impact on Mortgage and Stock Rates

The Fed’s hike will cause other interest rates to rise, some directly and others indirectly.

A higher federal funds rate directly increases the interest charged on the floating rate home equity lines of credit. They will increase by 0.5% within a billing cycle or two. These loans, also known as HELOCs, are often used to finance home renovations.

The Fed also has an indirect impact on mortgage rates, which rose steadily in March and April because markets knew the hike was coming. Mortgage rates are likely to rise further as the Fed has only hiked the federal funds rate twice this cycle and markets are anticipating several more hikes.

Lawrence Yun, chief economist for the National Association of Realtors, noted that the interest rate on 30-year mortgages has risen far more than the federal funds rate this year. “This means that the market is already pricing in about eight to ten rounds [Fed] Rate increases this year,” Yun said in an email. “If inflation gets higher, the Fed needs to be even more aggressive, and that will continue to push mortgage rates higher.”

How Expensive Mortgages Shrink Inflation

Typically, the Fed increases the federal funds rate by 0.25% at a time. But no one would describe today’s economy as typical. The consumer price index, a measure of inflation, hit 8.5% in March, the highest level in more than 40 years. The Fed is demonstrating its seriousness about rolling in inflation by raising the federal funds rate by twice the usual hike.

“We’re really committed to using our tools to get inflation back to 2%,” Fed Chair Jerome Powell said April 21 during a panel presented by the International Monetary Fund.

You might see increasing the cost of buying a home as an odd way to take control of runaway price increases. But higher mortgage rates could put a damper on soaring home prices as many homebuyers shop with one monthly payment. If mortgages become more expensive, homebuyers could be forced to look for cheaper homes, which could slow home price increases and in turn dampen inflation.

Take someone’s hypothetical example who can afford it $1,700 a month in mortgage principal and interest, and who started buying a home in February. At that time, the 30-year fixed-rate mortgage averaged around 4%. Let’s say our home finder finally made a winning bid in late April when the 30-year mortgage was up to about 5.25%. Here’s how the rate hike affects the amount this buyer can afford:

  • At 4%, the buyer can afford to borrow $356,100.

  • At 5.25%, the buyer can afford a $307,900 mortgage — a $48,200 loss in creditworthiness.

HELOC borrowers and home sellers are not being spared

Higher interest rates affect more than homebuyers. They’re also changing the math for HELOC borrowers and home sellers.

Interest rates on adjustable-rate HELOCs are tied to the federal funds rate, which moves in step with the federal funds rate. Homeowners with balances on their HELOCs can see their interest costs increase as the interest rate rises. For every $50,000 owed on a HELOC, a 0.5% rate increase adds $20.83 to monthly interest.

Home sellers need to remember that higher mortgage rates reduce affordability. It might be worth checking whether buyer pre-approvals are based on current mortgage rates, rather than the lower rates seen a few weeks ago.

And as fewer and fewer people can afford to own a home at today’s higher mortgage rates, sellers may find that they can no longer rely on getting multiple bids. This situation should be taken into account when setting an offer price.

See also: If Roe v. Wade is repealed, what happens to the housing markets in states with “trigger” laws that would ban abortion outright?

Mortgage Rates May

Mortgage rates are more likely to rise than fall in May because the Federal Reserve may signal at its June and July meetings that it will continue raising short-term rates in half a percentage point increments. With the central bank taking such an aggressive monetary policy stance, mortgage rates will almost certainly rise to keep up.

If mortgage rates fall instead, the most likely cause would be a geopolitical crisis.

What happened in April

At the end of March, I predicted that mortgage rates would keep going up because they aren’t done yet. That prediction was equivalent to looking out the window of an airplane three minutes after takeoff and predicting that the airplane would continue to climb for a while. In other words, I didn’t base the prediction on thorough analysis. I looked out the window metaphorically.

I guessed right. Mortgage rates skyrocketed. The interest rate on the 30-year mortgage averaged 5.09% in April, up from the 4.37% average in March.

More from NerdWallet

Holden Lewis writes for NerdWallet. Email: Twitter: @@HoldenL. How do higher mortgage rates help reduce inflation? Here is an explainer.

Brian Lowry

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