Interest rates are the effective cost of borrowing money. In the UK, the base rate (repo rate) is set by the Bank of England, Monetary Policy Committee. In the US, interest rates are set by the federal reserve.
Central Banks typically set interest rates in order to try an meet an inflation target. In the UK this inflation target is CPI = 2% +/- 1. Basically this means that if inflation is forecast to rise above the target the Bank will raise interest rates in order to reduce spending in the economy and therefore moderate inflationary pressures.
How Interest Rates affect the Housing Market
1. Increased Mortgage Payments. An increase in interest rates will increase monthly payments on a variable mortgage. A quarter point rise on a £ 140,000 mortgage can increase monthly payments by upto £ 30 per month.
2. Demand for Housing. Sustained Rise in Interest rates will affect the affordability of paying a mortgage. As interest rates rise, buying a house becomes less attractive and therefore demand falls. This can lead to falling house prices. Eg in 1992 interest rates rose to 15% causing house prices to collapse in the UK.
Why Rising Interest rates may not cause House prices to Fall.
1. Time Lags. If you have a house and mortgage a rise in interest rates is absolutely to make you sell your house, unless it becomes very serious. Usually a rise in interest rates will not reduce demand straight away, it can take upto 18 months to have the full effect.
2. Confidence. If confidence is high, people may respond to rising interest rates by continuing to spend money. This leads to a fall in the savings ratio and demand for housing does not fall.
3. Other Factors that affect Housing Market. Interest rates are an important factor, however, it depends on basic supply and demand analysis. If there are severe supply contracts (like in the UK) house prices may continue to rise, even though interest rates are higher.
4. Real interest rates. It is important to bear in mind that it is real interest rates, which affect the affordability of housing. If interest rates are 10% but inflation is 9% the real interest rate is only 1%. This means that despite interest rates seem high, in practice the real cost of borrowing is quite low.
Factors that determine effects of interest rates on Housing Market
5. Types of Mortgages. Rising interest rates are having a big impact on America because of the high% of sub prime mortgages. This means that many homeowners have obtained a mortgage by borrowing a high percentage of their disposable income. In other countries, where mortgage lending is stricter, many homeowners would have been unable to get such adverse mortgages. Therefore rising interest rates can make the difference between being able to afford mortgage payments and defaults.
6. In the UK rising house prices mean that more first time buyers are borrowing upto 5 or 6 times income. Therefore, mortgage payments account for a higher% of income.
7. It depends on ratio of Fixed vs Variable Mortgages. If homeowners have a fixed rate mortgage then rising interest rates will not have any effect; at least until they come to renegotiate another fixed rate contract in 4 years time. In Europe more homeowners have a fixed rate mortgage so the European housing market is less sensivivie to interest rate changes.