How Interest Rates Affect the Housing Market

Nowadays, everyone is watching interest rates in light of the economic changes. It makes sense because interest rates affect things such as inflation, savings returns, mortgage rates, borrowing costs, and many more. For someone interested in real estate, this could influence their decision to invest in a certain property.

To paint it in a simple picture, interest rates rise when we reach a good economic turn, as the demand for property increases. The interest rate in 2025 is somewhere around 6.5% for mortgages, which is a stark difference from the 3.25% set for 2021.

Understanding what causes these changes is crucial for real estate investors because it helps them determine when to buy and when to sell. For this purpose, this article will explain more about how interest rates affect the housing market.

What Are Interest Rates and Who Sets Them?

Interest rates represent the cost of borrowing money. It’s like a service; when the bank gives you a loan, you get charged a certain percentage of the loan that you are borrowing. There are two types of interest rates that you can come across: the Federal Funds Rate and the mortgage rate.

The Federal Fund Rate is a short-term rate set by the Federal Reserve (Fed), influencing how much banks can lend to each other overnight. It’s a tool meant to control inflation, economic growth, and employment, virtually regulating the monetary policy.

When inflation goes higher, the Federal Reserve raises interest rates to slow down borrowing, so the economy can cool down. On the other hand, if the inflation is low, the Fed lowers these rates to encourage borrowing. This includes the housing market since more people can afford homes if they don’t have to pay loads of money just to borrow.

The Fed doesn’t set the mortgage rates directly, but it is indirectly influenced by them. When the Fed raises these rates, bond yields go higher as well. Banks increase their loan rates in response, which includes mortgages. The real estate supply and demand cause the rates to hike in demand, even if they aren’t technically controlled directly.

How Interest Rates Affect Mortgage Costs

One of the most common points where interest rates and real estate meet is through mortgage costs. If the rates go higher, so do the monthly mortgage payments. This reduces the buyer’s ability to buy a property, even if the loan principal is technically the same.

For example, let’s say that you have a $300,000 mortgage set at a 4% interest rate. Should this happen, you’ll have to pay about $1,432 per month for your home payment. However, if the rate goes up to 7%, you’re stuck with a monthly payment of somewhere around $1,995 a month. That’s more than an extra $500.

Seeing as the average rent in the US is around $1,626, this is more than a first-time homebuyer can afford. At this point, people may be more inclined to keep renting rather than buying their own house. Someone who wants to upscale could also end up paying more money for a much smaller house, making the investment not worth it.

Impact on Housing Demand

Changing interest rates also affect the housing demand. Mortgage rates are basically what makes a home affordable or not, and even the smallest changes can influence one’s decision to buy a home. Since the monthly payments go up, would-be buyers can no longer afford the monthly payments or may not qualify for loans at all.

Higher Mortgage Rates Reduce Buying Power

Since people are no longer buying homes, this leads to a real estate market slowdown. We see fewer showings and bidding wars, and sellers no longer get as many offers as before. The whole thing turns into a waiting game where buyers hope for better rates and sellers hold out until they get a good offer.

First-time buyers are hit the hardest in this scenario since they don’t have equity to offer. Their down payment capital is low because they have no first home to sell, and they can only rely on their income. Even a 1% increase could push the monthly payment past their budget, making them pause their search or exit the market entirely.

Lower Mortgage Rates Reduce Demand

On the other hand, low rates drive demand. For example, the Fed cut interest rates in response to the pandemic, which caused mortgage rates to follow. At that point, the average mortgage rate for a 30-year plan was around 2.9%, an unprecedented low.

All of a sudden, people could buy homes, which increased demand. However, these rates set different expectations for homeowners, making them unwilling to pay more when interest rates went up again.

Impact on Housing Supply

Interest rates don’t just affect the demand. They have a significant impact on the housing supply as well, for both current homeowners and developers. Selling is no longer a profitable option, which means that everyone is holding out for better opportunities.

Effect on Homeowners

During times of high interest rates, homeowners go through a phenomenon called the “lock-in effect.” Many of these people bought or refinanced their homes during the pandemic when the interest rate was barely 3%.

If they try to sell and move out now, when the interest rate is over 6%, they could end up paying massive monthly payments, even if they moved into a similarly priced property.

This makes many decide that the best thing to do right now is to stay where they are. Even if they want a change of scenery, swapping mortgages is rarely worth the effort. This leads to fewer properties entering the real estate market and a smaller inventory. This could consequently cause higher home prices since potential homebuyers are fighting over the few homes available.

Effect on Developers

Real estate developers and builders are hit just as hard by the rising interest rates. Most construction projects are financed by loans. Needless to say, if the interest rates go up, so does the cost of borrowing. This makes it difficult to afford things such as land, construction materials, labor, and more.

When you combine it with low demand from buyers, this makes developers second-guess the worth of going forward. After all, who wants to spend loads of money building a house when people don’t want to (or can’t) buy?

When the interest rates started hiking again in 2022, building rates declined by 16.04%. This further suggested there would be fewer houses to choose from in the future.

Effects on Home Prices

Whether you are a buyer, seller, or investor, you’ll likely ask yourself one question: If interest rates go higher, will the prices fall? You’d think this would happen due to the low demand in homes. After all, if sellers want to make the property more attractive, they’d have to reduce the price.

Well, that’s not necessarily the case. Sure, if prices hike up, it lowers the home purchasing power. This leads to a weaker demand, which puts pressure on prices. However, rather than going down sharply, the prices just slow their growth or enter a plateau. This just gives the illusion that prices are lower, although there are still some sellers who give in.

For example, in 2022-2023, interest rates hiked and caused the prices to decline in some areas. That said, in other areas, prices remained stable.

Markets such as Austin or San Francisco can recover quickly from this, whereas the Midwest could have a weaker reaction. Places with high-stakes environments could prompt sellers to hold onto the property, especially if they aren’t particularly in a hurry to sell.

This could indeed lead to a sluggish market where real estate activity is low, but it doesn’t mean a price collapse will follow. More often than not, it just enters a waiting game.

Real Estate Market Trends and Investor Considerations

Rising interest rates don’t just affect homeowners who want to relocate. It affects those who choose to invest in real estate, especially when it comes to house flipping.

Here’s what to look into when analyzing real estate investment and interest rates:

1. Lower Cash Flow

When investors buy a property with a short-term plan and a variable rate, rising interest rates could increase the monthly debt. The borrowing costs become higher, which reduces the cash flow. The only ones who may not be potentially affected are those with fixed rates or long-term rental investors.

2. Higher Cap Rate

With borrowing costs going higher, cap rates follow suit. This number is the ratio between the property’s net operating income (NOI) and property value. If the market doesn’t yield, investors have to increase their cap rate so they can continue attracting investors. Not many may have the financing to successfully do that. It could also cause investors to become more selective as they look at break-even analyses or rent-to-price ratios.

3. Refinancing Risks

A lot of investors who bought a property during pandemic times either went for short-term bridge loans or ARMs. When it’s time to start paying the loan, it might be more expensive to refinance at a higher rate. Plus, there’s a good chance the value of the asset could have dropped in the meantime.

On the plus side, downturns can bring more opportunities for cash buyers and long-term investors. They’ll have less competition and better leverage for negotiations, potentially striking a better deal. It’s a good idea to use tools such as REI Lense to check investment projections, which allows you to stay ahead of the curve in shifting markets.

When Low Rates Can Also Be a Problem

Low interest rates are very often a good thing, but they also have the potential to be problematic. For example, low rates could overheat the market, since people are constantly buying houses. With more people affording credit, buyers try to compete with one another and bid more than the asking price.

This could lead to a sharp growth in prices, causing something we call a “bubble.” At this point, home prices are no longer based on what they are really worth. In the end, mortgage payments become manageable, but people pay more for down payments.

Eventually, housing can become unaffordable, despite the rates lowering. This happens because home prices are skyrocketing faster than the median household income can keep up with. Such a thing can be particularly troublesome for those buying a house for the first time.

The Bottom Line

Interest rates drive the housing market in more ways than we can imagine. They affect the cost of the mortgage, supply and demand, prices, and even ROI. It’s always a good idea to use tools such as REI Lense to navigate through these changes. A mortgage rate calculator can be useful to determine things such as payments, returns, and the cost of property ownership.