With interest rates at an all-time high, there’s been a lot of focus on when they’ll start to drop, but what are the implications for the real estate market?
In this post, I’ll explain how rate cuts affect the real estate market, as well as the “Overnight Rate” that often appears in general interest rate articles.
What is a rate cut?
An interest rate cut means that a central bank lowers its benchmark interest rate. This is done to lower the interest rate on loans, which reduces the amount of money you have to pay to banks and others when you borrow money (the cost of borrowing).
The cost of borrowing refers to all the costs that an individual or business incurs when they borrow money. The interest cost on a loan is the largest part, but it can also include other costs associated with borrowing.
So a rate cut directly affects the interest rates of many financial products, including mortgages (home equity loans).
How rate cuts affect the interest rates of commercial banks’ financial products
- Adjustment of a central bank’s policy rate:
- When a central bank (such as the Bank of Korea) cuts interest rates, commercial banks are able to reduce their interest costs. This is reflected in lending rates, resulting in lower interest rates for mortgages and other loans.
- Reduced borrowing costs:
- Banks often borrow from central banks when they need to raise funds. When the policy rate is lowered, the cost for banks to borrow money from the central bank is reduced,
and the interest rates on the loan products offered based on it are also lowered.
- Banks often borrow from central banks when they need to raise funds. When the policy rate is lowered, the cost for banks to borrow money from the central bank is reduced,
- Indexed to market rates:
- The interest rates on many financial products are tied to a benchmark interest rate. When the benchmark interest rate is lowered, the interest rate on variable-rate loans is automatically lowered accordingly.
- Increased competition:
- Lowering interest rates fosters competition among banks, as each bank tries to attract customers by offering lower rates on loans, which tends to lower rates across the board.
- Changes in bond yields:
- A rate cut will also affect the bond market, causing bond yields to fall. Banks will adjust their lending rates to account for this, so interest rates on mortgages and other loans will also fall.
- Banks rely on bond yields as an important indicator in their funding and operations. When bond yields fall, banks’ funding costs are lower, which in turn drives down lending rates.
How will the rate cut affect mortgage rates at commercial banks?
- Reduced borrowing costs When interest rates drop, variable and fixed-rate mortgage rates also drop, reducing the cost of borrowing. This allows homebuyers to borrow at lower interest rates, resulting in lower monthly payments, which in turn increases their affordability.
- For example, a 0.25% reduction in your mortgage rate this July 24 could reduce your payment by $95 per month, or $1,140 per year.
- Increased housing demand Reduced borrowing costs can increase housing demand by making homeownership less affordable. This can lead to a revitalized housing market, resulting in more sales transactions.
- Rising home prices Increased demand for housing can lead to increased competition for listings, which can increase home prices. This can cause home prices to rise because cheaper loan terms due to lower interest rates encourage more people to buy homes.
- Reducing interest burdens for existing borrowers Existing borrowers with variable-rate loans can benefit from lower monthly payments due to lower interest rates. This can have a positive impact on household finances and increase their spending power.
- Boosting real estate investments: Low interest rates are also beneficial for real estate investors. Lower lending rates make real estate investments less expensive, encouraging more people to invest. This can also have a positive impact on the commercial real estate market.
What is the Overnight Rate?
Sometimes you’ll see the name Overnight Rate appear before the rate.
The overnight rate is the interest rate that financial institutions charge when they borrow funds from other financial institutions overnight.
The overnight rate is a very short-term policy rate set by central banks, which indirectly affects the interest rates on all financial instruments. On the other hand, the “prime rate” refers to the actual interest rates that apply to various financial instruments.
By controlling these short-term rates, central banks also influence long-term rates, which in turn affect the interest rates on a variety of financial instruments, including mortgages, business loans, and more.
Experts weigh in on the latest rate cut
The Canadian Mortgage Brokers Association and CIBC, among others, saw this as a very positive sign, and many experts agree that the two recent rate cuts appear to be a definitive signal for the direction of interest rates going forward.
However, many experts also believe that it will take more than four or five of these small steps and a drop in fixed rates below 4% for the market to show meaningful change.