Homebuying and the Economy: How Interest Rates and Inflation Affect Your Purchasing (and Remodeling)

It’s been a bit of an up-and-down ride for mortgage rates over the last couple of years — and mostly down. But that’s now changing. The new Federal Reserve chair, Jerome Powell, has said as much, and at March’s Fed meeting, rates were raised one quarter of a percentage point. Three to four more hikes are expected through 2018. But how does that affect the economy, inflation, and, most importantly, your ability to purchase, refinance, or renovate your home?

The Basics

Let’s start with understanding what inflation is.

The basic definition of inflation is an increase in prices, leading to a reduction in purchasing power. That is, you can’t buy as much with your money as you could previously. Inflation generally goes up in a strong economy, when people have disposable income and demand matches or exceeds supply. Conversely, inflation lowers when the economy is uncertain and people are spending less money. In a stable economy, wages rise to match inflation, so that higher costs are still manageable and people can still keep the economy moving by making purchases and circulating cash.

When Inflation Rises, So Do Rates

The Federal Reserve is charged with balancing inflation, supporting low unemployment and stable prices, and keeping the economy on track. One way they do this is by controlling interest rates, known as the Fed Funds Rate. The Fed Funds Rate is the interest rate banks are charged to borrow funds to maintain their cash reserve requirements. When the reserve requirement is raised, banks have less money to lend, and so rates rise.

Additionally, when unemployment is very low, as it is now, the Fed will raise interest rates so that demand — determined by all the money people are making and ready to spend — does not outpace supply. As such, higher rates encourage people to save their money, as it will earn better interest. At the same time, it becomes more expensive to borrow money.

Unemployment in our country is extremely low, so the Fed has raised interest rates to slow our spending down in an attempt to keep inflation in check. As you can see, a strong economy can trigger inflation to grow, pushing up interest rates and making it more expensive to borrow money.

As inflation goes up, purchasing power goes down

As inflation goes up, interest rates rise

As inflation goes up, it’s more beneficial to save than to spend

Your Purchasing Power Today

Although the moderate Fed rate hike won’t lead to crazy inflation spikes, it’s still going to affect your buying power, and you won’t be able to buy the same items and services for the same cost as you once could. Mortgages will cost more, as will renovation loans, of course; but the home improvement projects and upgrades you want to make are also affected, and you’ll be paying more for project materials, from tools to tiles to paint and supplies. Even brand-new homes will cost more as the price of lumber and labor will go up. And remember, several more hikes are expected this year.

The Takeaway

Of course, we can’t predict exactly how much prices and inflation will rise over the course of 2018. What we do know is that mortgage interest rates are still at historic lows, but we know they are set to rise this year; that home prices are generally affordable, but inching up; and that inflation will probably soon be on the rise: all factors which make now the right time to buy, refinance, or renovate a home.