A 0.75% reduction in the Federal Funds Rate will revitalize the real estate market

Well, unofficially it's official: September will almost certainly see a rate cut. This is what we've all been waiting for: a lower rate to dampen the chronically high housing prices that have been a big part of the post-COVID-19 economy. According to rumors and the CME FedWatch Tool, we're likely to see only a 0.25% rate drop in September.

While anything can help, I don't think it's enough to make a huge difference right away. However, CME is predicting a rate cut of up to 0.75% by the end of the year and that definitely caught my attention. Although the Federal Funds Rate doesn't directly affect mortgage rates, it does have a big impact on them.

The difference of less than one percent makes

As of Thursday, August 22, the Federal Reserve Bank of St. Louis reports that the average interest rate on a 30-year fixed-rate mortgage is 6.46%.

If we start at 6.46% and end up somewhere between half and three-quarters of a percent, that's a pretty serious shift in the psychology when it comes to interest rates. We'll no longer be in the 6% range, but we'll be dipped into the 5% range – a fifth, as those in the know like to say.

And while this is certainly tempting and should lead to many new applications from mortgage lenders, the question is, does it really make a difference to people's financial capabilities?

Considering that those of us who have secured an interest rate of 4% or less—a whopping 62% of homeowners with mortgages—might even be interested in putting our homes on the market when presented with a 5% interest rate, perhaps that's possible.

After all, a 5.8% mortgage still sounds like a mortgage that's only 1 percent higher than what we're paying for a home we've long outgrown and are desperate to swap out. That would go a long way toward countering the pricing pressure that's still high due to limited inventory. Even though inventory has risen to four months' worth, that's still well below a balanced market.

Who will step in with a five-grip?

When interest rates fall, homes become more affordable – assuming prices do not rise.

If owners at 4% and below start selling at higher rates, it is still very plausible that home prices will remain stable as inventory increases as we too will be looking for homes.

However, the difference between a 6.5% mortgage payment and a 5.75% mortgage payment can be quite large, as shown in the table below, which calculates monthly mortgage payments based on three different mortgage amounts (these figures include only principal and interest, not including any additional add-ons such as mortgage insurance).

Data source: Author's calculations.

For borrowers with significant equity, such as the 4% borrowers, the debt-to-income ratio may not matter as much since we will be able to make sizable down payments. However, for first-time home buyers, even a small change in the interest rate can open up the market to more and more previously inexperienced buyers.

As of 2022, the real median household income in the U.S. was $74,580, or $6,215 per month. If the median home sales price is $412,300, we can reasonably expect an average first-time borrower to be in that loan range between $300,000 and $400,000, depending on the down payment. Last year, the average down payment for a first-time borrower was 8%.

Although conventional mortgages sometimes allow a debt-to-income ratio of up to 45%, FHA loans, for example, require that the mortgage portion of your payment does not exceed 33% of your income. I've created a table for this as well. Let's see what the DTI is for different payments compared to the average household income.

Data source: Author's calculations.

For every quarter-point rate cut, the average borrower above is 1% further from the ceiling of their debt-to-income ratio, increasing their chances of getting approved for a loan. With good enough credit and low enough debt, they can borrow at literally any price range on the chart. Still, every quarter-point rate cut represents $155 in other debt that may coexist alongside that mortgage.

You have a personal loan payment of $300? You are in the range of a $300,000 FHA mortgage at 6%. You just bought a nice used car for $600 a month? You easily fit into a $400,000 conventional loan at 5.75%

Where there’s smoke, there can be fire

With so many potential buyers out of the picture and back on the market by year's end, 2025 could look very different from the frustration many potential homebuyers have experienced over the past few years. The lower the interest rate, the more of the 4%ers will hand over their golden handcuffs and the more homes will be on the market for sale.

The downside of this, of course, is that many first-time buyers could also decide to jump in, which would drive prices up again as the housing market not only heats up but explodes.