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Since most houses are purchased with borrowed money, changes in interest rates do affect the housing market, most commonly through changes in mortgage rates.

What is the Interest Rate?

Interest rates are the rates at which money can be borrowed for a set period of time. The higher the rate, the more interest the borrower will have to pay back on the loan. The US Federal Reserve sets the rate at which it lends money to major financial institutions, including banks. Banks base their interest rates off of the rates they receive from the Reserve. Therefore, when the Federal Reserve lowers rates, banks might also lower the rates at which they lend out money.

Why Does the Interest Rate Matter?

Generally speaking, low interest rates mean more people are able to borrow more money at less cost–since they will have to pay back less interest over time. This mean home buyers are more likely to get lower rates on their mortgages, making it easier to pay off their house. When the interest rate rises, borrowing becomes more expensive and home buyers can expect to see higher monthly mortgage payments.

But changes in interest rates have other effects, too. The number of home sales tends to rise when interest rates are low, because more people can afford to buy. This increases demand, possibly leading to a “seller’s market” (a market characterized by more buyers than available properties) or an increase in new home construction. The construction companies are not just responding to the potential increased demand; lower rates means it is also cheaper for them to finance their projects.

That said, lower rates do not necessarily mean a stronger housing market, and they certainly do not guarantee lower house prices. Sometimes lowering rates can backfire; if the supply of homes increases too quickly it might outpace demand, causing home prices to fall.

Rather than expecting to see the effects of interest rate changes reflected in housing prices, look for them in changes in mortgage rates. Depending on the type of loan you used to buy your home, you might be able to refinance your loan when rates go own, saving you a substantial amount of money in the long term.