The current Federal Reserve Board - the group that sets interest rates - has a history of worrying about inflation as well as recession. It will not hesitate to raise rates quickly if it believes inflation is on the way. It is worth noting the detrimental effect of inflation on mortgages and the real estate market in general. There are two basic reasons for inflation.
1. The first reason is if the economy is booming. Companies are expanding and competing for workers by offering higher salaries. The jobless rate is very low. Since more people are working for high wages, they buy more things, such as cars, appliances, and clothes. This higher demand causes higher prices (inflation). To keep the inflation rate under control, interest rates are increased. This causes less expansion and spending, lowering the demand for both workers and products.
2. The second reason for inflation is if the economy is slow but prices of goods are rising. Oil prices, for example, may be high. If oil prices stay high for a sustained period, it costs more for companies to produce products and offer services. This results in lower profits and, eventually, losses. The companies first try to increase productivity by closing unprofitable factories, retail stores, etc., which causes layoffs. They also reduce workers' benefits and attempt to negotiate pay cuts with unions. Once it is no longer possible to fight the rising costs by increased productivity, they pass the increased costs on to the consumer. Since there are fewer jobs and lower wages, there is less demand for products and services.
Even though demand is lessened, prices do not fall because of the higher production costs. Interest rates go up to further add to the problem. The result is a lower standard of living until a solution is found to resolve what is keeping production costs - and thus, prices - high.
If you want to sell your home, you need a buyer. When interest rates are low, more potential buyers qualify for mortgage loans. The low interest rates mean low monthly payments. Every time there is an interest rate increase, a number of buyers no longer qualify. Others now qualify only for lower loan amounts. Unlike a business, you cannot increase productivity. The only thing you can do to sell is to reduce your asking price.
Example: If your home is worth US Dollars 200,000 with interest rates at 5%, it may only sell for US Dollars 150,000 if rates go to 8%. If you still owe US Dollars 180,000 on your mortgage, you can see the problem that you face. Since the interest rate is higher, the buyer is not really getting a bargain if you do sell at the lower price.
Fortunately, real estate is called a self-correcting asset. If you bought Enron stock for US Dollars 100 per share, you have lost your money no matter how long you hold the worthless shares. If you paid US Dollars 200,000 for your home and it is now worth US Dollars 150,000, do not worry; if you hold it long enough, it will eventually increase in value and could be worth US Dollars 250,000 some day. The question of how long you will have to hold it for the value of the house to go back up is the unpredictable part.
As discussed throughout this article, many of the decisions regarding mortgages should be based on how long you keep the loan. How long you plan to stay in your home should be decided before you start your mortgage shopping. Only about 5% of thirty-year mortgages are paid off in thirty years. Since you cannot depend on favorable interest rates for refinancing, your plan should be based on how long you plan to stay in your home before selling. Then you get the loan best suited to your five-, ten-, fifteen-, or twenty-year (or longer) plan.
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