Interest Rates And How They Influence The Housing Market

The interest rate on your loan is the effective cost of borrowing money. In the United Kingdom the base rate is set by the Bank of England, Monetary Policy Committee while in the US the interest rates are set by the Federal Reserve.

Central Banks will usually set the interest rate level in order to try and meet an inflation target. For example in the UK this inflation target is CPI = 2% + / - 1; it basically means that if inflation is forecast to rise above the target the Bank will raise the interest rate level in order to reduce spending in the economy and therefore moderate inflationary pressures.

An increase in the interest rate level will increase monthly payments on a variablemortgage. A quarter point raise on a $140,000mortgage can increase monthly payments by up to $30 per month. Also a sustained rise in the interest rate levels will affect the affordability of paying amortgage. If the interest rate rises, buying a home becomes less attractive and therefore demand falls. This can lead to the falling of house prices just like what happened in 1992 when the interest rate levels rose to 15% in the UK causing house prices to collapse.

Now if you already have a house and a mortgage, a rise in the interest rate levels will unlikely make you to sell your house, unless of course it becomes very serious. Usually a rise in the interest rate levels will not reduce demand straight away, it can take up to 18 months to have the full effect. However if confidence is high, people may respond to rising interest rate levels by continuing to spend money, this will lead to a fall in the savings ratio but the demand for housing doesn't fall. Now although the interest rate levels are an important factor on the housing market, they depend on basic supply and demand analysis. If there are severe supply constraints, house prices may continue to rise, even though the interest rate levels are higher It is also important to bear in mind that it is the real interest rate that actually affects the affordability of housing. If for example the interest rate is 10% but inflation is 9% the real interest rate is only 1%. This means that even if interest rate levels seem high, in practice the real cost of borrowing is quite low.

Rising interest rate levels are having a big impact on America because of the high percentage of sub prime mortgages. What this means is that many homeowners have got amortgage by borrowing a high percentage of their disposable income. In other countries, where mortgage lending is more strict many homeowners wouldn't have been able to get such adverse mortgages. Therefore rising interest rate levels can make the difference between being able to affordmortgage payments and defaults.

In the UK for example, rising house prices mean that more first time buyers are borrowing up to five or six times their income. Therefore,mortgage payments account for a higher percentage of income.

If homeowners have a fixed ratemortgage then rising interest rate levels will not have any effect; at least until they come to renegotiate another fixed rate contract in four years time. In Europe for example, more homeowners have a fixed ratemortgage so the European housing market is less sensitive to interest rate changes.

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