Inflation and mortgage interest rates: What to know

It’s no secret that the housing market is linked to the ups and downs of the larger economy. Inflation can play a role in this relationship by impacting interest rates, which, in turn, affect mortgages. If you’re a homeowner or currently in the market for a home loan, it might be wise to get a handle on how inflation and interest rates interact so that changes in the economy are less likely to catch you by surprise.

What is inflation?

Before diving in, let’s explore what inflation is. Put simply, inflation is the rate at which the general prices of goods and services rise over time. In everyday language, people tend to think of “inflation” when these prices accelerate faster than usual over a sustained period. It’s often measured by the Consumer Price Index (CPI) or the Producer Price Index (PPI), both of which reflect changes in the cost of living.

Inflation is typically caused by a combination of factors such as increased demand for products, higher production costs or even changes in government policies. When demand for goods and services outpaces supply, prices tend to rise, leading to inflation. On the flip side, if the economy is experiencing a period of slow growth or contraction, demand for products and services may decrease, potentially causing prices to stabilize or even drop, resulting in lower inflation rates.

For inflation to fall, there usually needs to be a shift in the balance between supply and demand, or an intervention via monetary policy enacted by the government or central banks to curb the upward pressure on prices.

What happens during inflation?

When inflation rises, it can begin to erode the “purchasing power” of your money — meaning you’ll need more cash to buy the same goods or services as before. To counteract this, central banks may increase interest rates, making borrowing more expensive, to reduce demand and alleviate the upward pressure on prices.

Higher interest rates can impact various sectors of the economy. As borrowing becomes more expensive, people may hold off on big-ticket purchases such as homes and automobiles, in turn affecting the broader economy. Higher interest rates may also make business less inclined to borrow money for expansion. These factors, along with others, contribute to shaping the impact of inflation on numerous markets, including the housing market.

Inflation and mortgages

Now that we have a better understanding of inflation and how it might influence interest rates, let’s explore the connection between inflation, mortgage rates and what it all might mean for current and prospective homeowners.

Impact on new mortgages

When inflation causes central banks to raise interest rates, borrowing becomes more expensive, leading to higher costs for new mortgages. As a result, if you’re in the market for a new home, rising inflation could make your monthly mortgage payments more expensive, depending on the terms and type of your mortgage.

Difference between ARM and fixed-rate mortgage interest rates

Understanding the difference between adjustable-rate mortgages (ARMs) and fixed-rate mortgages may be helpful when navigating an inflationary environment. ARMs typically begin with an initial fixed-rate period, which can range from five to 10 years. During this time, the interest rate and monthly payments remain constant, just like with fixed-rate mortgages. However, once the fixed-rate period ends, ARMs transition to having variable interest rates that adjust periodically, making them potentially more sensitive to interest rate fluctuations. At that point, when interest rates rise, the monthly payments on ARMs may increase as well.

Fixed-rate mortgages, on the other hand, tend to have a consistent interest rate for the life of the loan. This means that your monthly payments will remain the same, regardless of changes in interest rates in either direction.

Refinancing during high inflation

If you already own your home, an increase in inflation might also make it more costly to refinance your mortgage. For those with fixed-rate mortgages, rising inflation and higher interest rates are less likely to impact your mortgage rates and your payments will typically remain the same. However, if you have an ARM that is beyond its fixed rate period, refinancing to a fixed-rate mortgage may make it possible to lock in a stable interest rate and potentially mitigate against future rate increases.

In contrast, if deflation occurs or interest rates are lowered, mortgage rates may become more attractive. This could potentially make it more affordable to buy a home or refinance your existing mortgage.

In summary

Navigating the housing market can take some planning, especially when factoring in the relationship between inflation and interest rates. Inflation tends to influence the central banks’ decisions to adjust interest rates, in turn impacting mortgage rates for homeowners and homebuyers. By keeping a close eye on the broader economic landscape and staying informed about inflation and interest rates, you’ll be better equipped to make well-informed financial choices.