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Fed: Homebuyers duck for cover
The Fed doesn't directly impact mortgage rates, but homeowners could still feel the effects.
March 23, 2005: 10:06 AM EST
By Sarah Max, CNN/Money senior writer
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SALEM, Ore. (CNN/Money) Homebuyers and homeowners can't count on the mortgage market ignoring the Fed forever.

As the Federal Reserve began its rate-hiking campaign last June, mortgage rates actually fell more than half a point, from 6.3 percent to about 5.6 percent in early February.

But when Fed chairman Alan Greenspan told Congress last month that the difference between the short and long rates "remains a conundrum," alarm bells were set off. As of last week, the 30-year fixed-rate mortgage hovered around 6 percent.

"This was the first of a few signals that long-term rates had fallen too low related to short-term rates given concerns of inflation," said's Greg McBride.

Tuesday, the Fed is expected to move again. And though the effect on long-term mortgage rates isn't direct, those in the real estate market have something to worry about.

Most economists are predicting that long-term rates will eventually move higher. The Mortgage Bankers Association, for one, is now forecasting that the 30-year mortgage will reach 6.6 percent by the end of this year and 6.9 percent by the middle of next year.

Slowing growth

Economists are quick to point out that rising rates often go hand-in-hand with an improving economy, meaning that better job prospects, higher wages and growing stock portfolios should offset the higher monthly payments buyers have to deal with when rates rise.

Still, higher rates, improving economy or not, could be a deal breaker for buyers in the priciest markets.

If rates went from 6 percent to 7 percent, the monthly payment on a $250,000 mortgage, for example, would jump from $1,499 to $1,663. Double the size of the mortgage and a rate increase would add several hundred dollars to the payment.

"Higher rates do have an impact on prices," said Thomas Skinner, managing partner of Redbrick Partners, a firm that invests in single-family housing and is forecasting a 75-basis point increase in mortgage rates by the end of the year.

"We find that a 1 percent increase in rates reduces prices about 3 percentage points relative to where they would be otherwise." In other words, if population growth or an improving economy point to a 10 percent increase in home prices, a 1 percent increase in interest rates will bring that appreciation down to 7 percent.

"Our forecast is that this year's price appreciation will be in the 3 percent to 5 percent range and next year will be below inflation," he added. "We don't expect nationwide decline but anyone who buys today expecting that prices will go up 10 percent a year is going to have a rude awakening."

Stretched to the limit

Higher mortgage rates will also hurt homeowners who have pushed the limits on what they can afford -- a growing group judging by the popularity of interest-only loans and new "option ARMS," which allow borrowers to pay less than the interest they owe on their mortgage.

If you financed your house with an option ARM (a.k.a. cash flow ARM), which adjusts every one to three months, you'll likely see the effects of a Fed rate hike within the next couple of months. Most of these loans are tied to the LIBOR (London interbank offering rate), which tends to track short-term rates in the States.

Home equity lines of credit will also become more expensive if the Fed raises rates because they are tied to the prime rate.

"The prime rate moves in concert with the Fed's interest rate moves," said McBride. "The average rate for a home equity line of credit has increased from 4.7 percent in June 2004 to 5.9 percent as of last week."

The minimum payment on a $40,000 HELOC at 4.7 percent would likely be around $155. But if at 6.15 percent (assuming the Fed raises another quarter point), you'd have to pay $50 more a month in interest.

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