Monetary Policy: Buying a Home - Essay Example

A Closer Look at Monetary Policy: Buying a Home Motivation and If the financial situation is to be excluded and no budgetary constraints were to be placed on buying a house, I would like to have a contemporary modern house in Florida, close the beach with an out door infinity pool. I would like to have at least six or seven bedrooms, a driving range, two tennis courts, an indoor heated pool with an eight person Jacuzzi and a living room that opens into a garden spread on one or two acres of land. Finally, just to make it look better, I’d like to have floors of Italian marble. The house would look something like the one shown below. This is an ultra luxury no expense spared house in the Florida Keys, the type of the house is Transitional Contemporary while the covered area of the house is 8,000 sq. ft (Henry, 2006). Coming back to the real world, we find that the income situation does not permit anything even close to the dream house described and shown above. In fact, based on the calculations made by Ginnie Mae (2006), the house I can afford should be about $130,000. I can not afford my dream house simply because it is fantastically expensive compared to my earnings and what I can feasibly secure a loan for (Bankrate, 2006). That particular house is a 3 Bed, 2 Bath, 1,019 Sq. Ft place which is located in Orlando, FL. and it was built in 1954 (Realtor, 2006). Nothing much can be done to solve the problem unless there is a sudden impulse of income for me because the dream house is far out of my reach. The amount of loan I can afford depends on my current income, the amount of available down payment, the current debt and the ability to return the loan over a given time period (Bankrate, 2006). To make the dream home a reality, I can hope to either win the lottery or work hard towards increasing my income in a substantial way. Since 2001, the housing market has seen its ups and downs but the general trend has been upwards. For instance, the lowest point came towards the end of 2001 where only 1,500,000 new housing units were started but the high point came in 2006 when more than 2,200,000 houses were started (Fed Reserve Bank of St. Louis, 2006). This data related to both the demand and supply for the houses since it shows the number of new houses which were created based on demand and satisfied by the supply. The most recent data shows a drop in the construction of new houses which have dropped to the levels shown in 2002. The last update in June shows that 1,850,000 new units being developed. On the other hand, the Civilian Noninstitutional Population has been on a continual rise since 2001 going from less than 215,000,000 to more than 228,671,000 in June 2006 (Fed Reserve Bank of St. Louis, 2006). This has a positive effect on demand since more people are competing for the same houses and since the number of houses being created is recently dropping the overall prices can be expected to rise. This is supported by the data provided by the OFHEO (2006) website. For Pennsylvania, the rise was 55.10% while the American average stood at 57.28% (OFHEO, 2006). Ginnie Mae informs us that the current mortgage rate for a 15 year loan is 5.625. For a 30 year fixed loan the rate stands at 6.68%. There are other financing options available but I would prefer to have a 15 year loan since the interest rate is lower and the payments would be completed in half the time even though the monthly payments would be higher. This would certainly mean 15 years of living in a tight belt, but that would also make the later years free of high mortgage costs when the kids are going to college. There are several factors that affect the rise and fall of mortgage rates around the country but primarily it the federal interest rates set by the Federal Reserve that governs interest rates for mortgages. In terms of the 15 and 30 year mortgage rates since 2001, they have remained close to the interest rates set by the Feds. The connection between the two is certainly obvious but mortgage rates are also affected by the demand and supply for housing to some extent. The federal rate is the rate of interest at which depository institutes loan out their holdings in the Federal Reserve to other depository institutes on an overnight basis (Arnold, 2005). This rate is different from the discount rate which the Federal Reserve uses to calculate loan payments for financial institutions. The federal rate has many important implications for the economy of the country and changes in this rate would affect everything from mortgage rates to the stock market. It also has a significant impact on economic growth depending on several factors in the monetary policy being followed by the country. Fundamentally, the Federal Reserve System operates to ensure that all American banks keep a certain level of reserves which are normally a percentage of the value of the bank’s demand accounts (Arnold, 2005). Since this is a regulatory requirement, banks may borrow money from each other to maintain such a level of reserves and the interest rate paid between banks would be the Federal Rate. Through these means, the Federal Reserve has considerable power over the supply and demand for balances of Reserve Banks. The current effective rate stands at 5.23%. The monetary experts at the Federal Reserve are supposed to ensure that the rate is set at such a level that it will create economic growth and stability in the economy. However, the economic demands have to be balanced with the political and social realties which may influence how and at what exact level the rate is set (Wikipedia, 2006). The Federal Reserve therefore adjusts the rate periodically to keep the economy running smoothly. However, even a slight change or even an expectation of change creates questions for the economic experts who have to reanalyze their estimates for the future of the economy. Since 2001, the interest rates steadily declined from their 2001 levels of more than 6% to less than 2% during an extended period from 2002-2005. Presently it has risen to high levels again and the reasons for this happening is simply the fed’s reaction to the state of the economy and the long term prospects for the economic situation. Consumer Prices Index shows that the cost of living is continually rising and has been on the up ever since data has been collected about the index. At the same time, the Gross Domestic figures from 2001 to 2005 also show a continual increase in amount from less than 9 trillion dollars to more than 13 trillion dollars. From the graphs of these items, there is no clear link between the Fed rate and these two elements of the economy. Analysis My interest rate meets up with the interest rates for mortgages which were present in 2002-2003. This rate is neither too high nor too low but can be seen as the close to the average rate for the five year period being examined. Comparing the Fed rate to the housing starts over the same five year period, it can be seen that there is loose connection between the two. For example, during the period between the start of 2002 and the middle of 2004, the fed rate remained relatively static. At the same time, the housing startups remained relatively flat with seasonal ups and downs. The fed rate indirectly affects the mortgage rates and that indirectly affects the building and purchase of houses but with two indirect links the fed rate has a muted effect on the housing markets. The current trend shows that interest rates are going down therefore a shorter fixed lower interest mortgage would be a good idea for any homebuyer. The market itself is appreciating in house values therefore I believe that buying a house would be a good investment in these times (HUD, 2006). While the Fed rate is thought to be a short term rate, it pressures long term lending rates up and down which are linked to treasury bills, consumer loans as well as mortgages (Luedeman, 2006). Expectations of the long term loan rates are usually not as variable because the fed rate adjustment happens many times over the life of a mortgage loan. However, several downward adjustments of the short term fed rate will bring down the interest rates for the long term contracts and vice versa (Federal Reserve, 2006). The adjustments in rates by the Federal Reserve change the risk-reward and scenarios for all investors. Suppose that long term interest rates fall due to continual downwards adjustments made in the Federal Rate, then the reward for having long term positions in any market will be reduced. All else being equal, an investor will look towards other investments where the reward is greater even when the risk of that investment is considered. While this may look and sound simple and there is a risk of thinking about the system as an easy method of controlling the economy, the reality of the situation is quite the opposite. No economist can claim to have perfect knowledge about the markets would react to a piece of information at any given time (Federal Reserve, 2006). The shape of the economy can be judged only to some degree despite the vast number of indicators which the Reserve has access to. It is to the credit to the economists at the reserve that they have worked with estimates and expectations for so many years, and managed to keep the system going. Conclusion The primary conclusion of the study is that buying a house is not an easy decision to make. While examining the various websites and the data on housing, it became clear to me that the house buying decision is certainly not something which can be made lightly. It seems that weeks or months of analysis and study will be required before I make a down payment and by the time I am ready to make a down payment on the house I can afford the market situation might have changed considerably. However, with the information provided to me in the course and the sources outlined in this paper, I believe that when the time comes I can make an intelligent decision about house buying based on my income and the amount of house I can afford. At the same time, location also becomes important because prices in different areas are higher or lower than others. Being informed and educated about these variables will certainly help me be confident about house buying decisions. Appendix Works Cited Arnold, R. (2005) Economics. South-Western Publishing. Bankrate. (2006). Calculators. Retrieved July 22, 2006, from Bankrate.com website: http://www.bankrate.com/brm/default.asp Department of Housing and Urban Development (HUD). (2006). Buying a Home. Retrieved July 21, 2006, from hud.gov website: http://www.hud.gov/buying/index.cfm Fed Reserve Bank of St. Louis. (2006). Economic Research. Retrieved July 22, 2006, from Research.StLouis.org website: http://research.stlouisfed.org/ Federal Reserve. (2006). The Federal Reserve System: Purposes and Functions. Retrieved July 22, 2006, from Federal Reserve website: http://www.federalreserve.gov/pf/pf.htm Ginnie Mae. (2006). A Guide to Owning Your Own Home. Retrieved July 21, 2006, from ginniemae.gov website: http://www.ginniemae.gov/ Henry, J. (2006). Ultra Luxury Custom Homes, Villas and Estates by design. Retrieved July 22, 2006, from DreamHomeDesignUsa.com website: http://www.dreamhomedesignusa.com/Contemporary%20Modern%20Plans.htm Luedeman, K. (2006). If the Fed raises rates - what does it mean for mortgage rates? Retrieved July 21, 2006, from Goodmortgage.com website: http://www.goodmortgage.com/News/2006/special_fed_rate_increases.htm OFHEO. (2006). House Price Index. Retrieved July 22, 2006, from Office of Federal Housing Enterprise Oversight website: http://www.ofheo.gov/HPI.asp Poole, W. (1998). Economic Growth: Is the Fed Irrelevant? Retrieved July 20, 2006, from Federal Reserve Bank of St. Louis website: http://stlouisfed.org/news/speeches/1998/07_15_98.html Realtor. (2006). Find a Home. Retrieved July 22, 2006, from Realtor.com website: http://www.realtor.com Wikipedia. (2006). Federal Reserve. Retrieved July 21, 2006, from wikipeida.org website: http://en.wikipedia.org/wiki/Federal_Reserve Read More