Rising interest rates have been a hot topic in the news lately. While some people believe that higher interest rates are good for the economy, small increases in rates can have far reaching effects on the economy as a whole that create an entirely new set of challenges. As a real estate investor looking for a hard money lender, it's important to understand how rising interest rates can impact the market. Keep reading to learn more.
What are interest rates and how are they determined?
At its simplest, an interest rate is the cost of borrowing money—which can be determined by a variety of factors. When a consumer purchases a good or service and pays for it with a loan, usually from a bank, then the interest rate applies to the total amount borrowed and is added to repayments. Generally, interest rates are set by various financial institutions based on the Federal funds rate defined by the Federal Reserve, which have a ripple effect throughout the financial system. This rate is based on multiple economic signals—like inflation levels, consumer demand, and unemployment figures—that give the Federal Reserve an idea of how much control they need over their currency. It directly affects the prime rates that a bank charges (the cost of borrowing money to the most credit worthy borrowers), because "the federal funds rate is the interest rate that financial institutions charge each other for overnight loans of reserves deposited at the Fed". This in turn, affects the way these financial institutions determine their respective interest rates so that they remain consistent with one another while also accounting for local business conditions. Ultimately, interest rates help lenders assess risk when lending money out, so rising interest rates have a ripple effect across the economy.
Why do rising interest rates affect the mortgage market?
Understanding how rising interest rates affect the mortgage market is essential for assessing the health of a given economy. Interest rates are closely related to the direction of the housing market. Generally speaking, when short-term interest rates rise so do long term rates and mortgage lenders increase their borrowing costs. This has an effect on both new mortgages and existing ones; borrowers with adjustable-rate mortgages are especially vulnerable as they must agree to higher monthly payments. In addition, current homeowners may find themselves unable to refinance at a lower rate of interest which reduces options for debt relief. Ultimately, any significant increases in short-term interest rates can have a wide-ranging impact on the mortgage market, affecting both buyers, sellers, and homeowners alike. For this reason, it is important for all stakeholders to remain informed about shifting trends in interest rates.
How do higher rates affect real estate investors looking for hard money loans?
When it comes to real estate investing, higher interest rates can often be a source of stress for investors. Much like banks, rising interest rates make hard money lenders, which are one of the most popular sources of alternative financing, more expensive.
"But wait-- private lenders are not banks! Why would hard money loan rates increase!?"
The answer to this question can help you understand the large-scale effects of changes in interest rates, even for alternative lending sources. Hard money lenders, private lenders, and fixed income investors often borrow money to lend out by leveraging their own credit and/or assets and making a spread on the interest rates. So, when the rate on their debt goes up, it gets passed along to potential borrowers to maintain a profit margin. So, analogous to the way banks are affected by the Fed, hard money lenders are affected by banks!
The increased cost of obtaining hard money loans ultimately leads to lower cash flow or profit for investors. Private lending is often secured against property with mortgages and carries higher interest rates than traditional bank loans (due to higher risk); if interest rates rise further, this may eat further into return margins for real estate investors. All in all, it is important for any prudent real estate investor to consider the impact of higher interest rates before deciding how to fund their next purchase. By being aware of the risks involved and thinking hard about the potential implications for cash flow or market values, investors can make better decisions regarding how to finance their investments. Remember, if you are financing with a fix and flip loan and plan to sell the house, potential buyers are navigating the mortgage market with higher rates as well. This affects the value of the project because a higher interest rate decreases buying power. Through careful planning, evaluation of financing options, and timely execution of project goals, real estate investors can minimize their exposure to higher interest rates and ensure a smooth investment journey!
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