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Sometimes, home sweet home is right under our nose. Buying a house from a relative may be the perfect solution, but everyone should be aware of how to negotiate and seal the deal.

An adult child may have her heart set on buying her parents’ home because of the memories it holds. Another might want to purchase Grandma’s home so he can retire in Florida. Others may have a relative who wants to give them a good deal.

Whatever the case, if you’re buying a house from family, you’ll want a harmonious handoff.

Buying a House From a Relative

It’s important to understand the home-buying process before making any real estate purchase.

And knowing what is needed to buy a home is useful before, erm, buying a home.

Buying a house from family, though, is a bit different than a deal between strangers. First of all, whether you’re a first-time homebuyer or not, it’s important to consider how crafting the deal can affect familial relationships.

Not hiring real estate agents might keep negotiations and planning all in the … family. If that’s the case, it’s a good idea to have regular check-ins to ensure that both parties feel good about the next steps and are ready to move forward.

It can be helpful to take notes about the arrangement after an initial meeting and make a copy for everyone involved so that all important details are in writing and available for review. That way, everyone is clear on what is expected of them.

Do We Need Real Estate Agents and Other Pros?

Even though buying a house from family is a personal affair, it can be helpful to bring in professionals to make sure the process goes smoothly, everything is done legally, and both parties walk away feeling satisfied and respected.

A lawyer or real estate agent can help make sure the purchase contract is done properly, state-required property disclosures are made, and the house sells for fair market value — what the property would sell for on the open market.

A title company can protect the buyer from any liens and ensure that no one else has a claim on the home. Even with a high level of trust between family members, this can be a smart step to take to protect the buyer.

And it can be helpful to consult a tax professional in order to be aware of any tax implications of the agreement.

Determine the Purchase Price

Deciding on the fair market value can be done by reviewing the sales price of recently sold comparable properties in the area of the home, or by hiring an appraiser to conduct an objective property valuation. Keep in mind that lenders usually require an appraisal.

Once both parties have an idea of the market value, they can decide how much the buyer will pay. In some cases, this will be the fair market value. In other scenarios, a family member may offer to pay closing costs, or provide a cash gift or gift of equity (described below).

Draw Up the Purchase Agreement

When both parties are ready to move forward, it’s time to draw up a purchase agreement. The legally binding real estate purchase contract will outline the price and payment terms.

Buyers who need a home loan can send the contract to their lender when applying for a mortgage.

Prepare for Scrutiny

There are two main types of real estate transactions: arm’s length and non-arm’s length.

In an arm’s-length transaction, the buyer and seller do not have a relationship and are acting in their own self-interest.

When someone buys a home from a family member, it’s a non-arm’s-length transaction. These deals may be subject to more scrutiny because the chance of mortgage fraud increases.

The sale price of the home must equate to what it would be between strangers unless a gift of equity is on the table.

A heads-up for anyone whose elder family member needs to go to an assisted living facility or nursing home and plans to fund their stay with Medicaid: To prevent Medicaid applicants from simply giving away a home or other resources to qualify for the low-income medical program, the federal government has a “look-back period” of five years. The exception is California, which has a 2.5-year look-back period that is gradually being phased out and will be eliminated by July 2026. A Medicaid applicant is penalized if assets were gifted or sold for less than fair market value during that time.

Know How the Gift of Equity Works

One thing sellers may want to consider is giving the relative a gift of equity, or selling for less than fair market value.

The maximum amount of the discount without reporting it as a gift to the IRS is $19,000 per recipient in 2025.

Spouses “splitting” gifts may each contribute $19,000 a year. Spouses splitting gifts must always report the gift. You and the seller can learn more about gift taxes on the IRS website.

That doesn’t mean sellers have to pay a gift tax; they can apply it to their lifetime gift exclusion. The lifetime gift and estate tax exemption is $13.99 million, or $27.98 million for a couple, in 2025.

So for the vast majority of people, the gift and estate tax exemption allows for the tax-free transfer of wealth from one generation to the next. Homeownership in general helps build generational wealth.

Here’s another plus for buyers: Most lenders allow the gift to count as a down payment.

A lender will require a gift letter signed by the sellers for a cash gift or a gift of equity sale. The letter will confirm that the gift is not a loan.

Know How to Finance the Home

When buying a home from a family member, many buyers will still need to take out a home loan. Even with a discount or a special offer from a family member, it can be hard to purchase a home outright.

Go with a mortgage broker or direct lender? Each has pluses and minuses.

Any mortgage loan officer or broker should be willing to answer your mortgage questions, including those about fees, points, and mortgage insurance.

Weighing different types of mortgage loans (including conventional conforming mortgages, jumbo loans, and government-backed loans) and loan terms (usually 30 years) can help you make a more informed decision.

After applying for mortgages, you’ll receive loan estimates. It’s important to compare mortgage APRs, fees, and closing costs.

After you choose a mortgage and close on the home, your mortgage servicing outfit will handle your payments.

The Takeaway

How to buy a house from a family member? For starters, consider calling in professionals, including a lawyer to help draft a contract. And make sure you and the seller understand how the gift of equity process works. But when everyone is well informed, buying a house from a relative can be seamless.

Looking for an affordable option for a home mortgage loan? SoFi can help: We offer low down payments (as little as 3% - 5%*) with our competitive and flexible home mortgage loans. Plus, applying is extra convenient: It's online, with access to one-on-one help.

SoFi Loan Products
SoFi loans are originated by SoFi Bank, N.A., NMLS #696891 (Member FDIC). For additional product-specific legal and licensing information, see SoFi.com/legal. Equal Housing Lender.

SoFi Mortgages
Terms, conditions, and state restrictions apply. Not all products are available in all states. See SoFi.com/eligibility-criteria for more information.

*SoFi requires Private Mortgage Insurance (PMI) for conforming home loans with a loan-to-value (LTV) ratio greater than 80%. As little as 3% down payments are for qualifying first-time homebuyers only. 5% minimum applies to other borrowers. Other loan types may require different fees or insurance (e.g., VA funding fee, FHA Mortgage Insurance Premiums, etc.). Loan requirements may vary depending on your down payment amount, and minimum down payment varies by loan type.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

External Websites: The information and analysis provided through hyperlinks to third-party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.

Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.

This article is not intended to be legal advice. Please consult an attorney for advice.

This content is provided for informational and educational purposes only and should not be construed as financial advice.

SOHL-Q424-128

Congratulations! You’ve found a house you love and want to buy. You may even be in the final stages of closing on this dream home. But sometimes, homebuyers may need to access what’s known as an escrow holdback: a way of setting aside funds at the closing for repairs that are most definitely needed as you take ownership.

For example, what happens if a blizzard hits the week before your scheduled closing, revealing a leaky roof that needs major (pricey) repairs?

This wasn’t something that showed up in the initial inspection report. Or, maybe it did show up in the inspection report, but the issue is suddenly much more pressing in light of said snowstorm. Either way, these repairs can’t be made at this particular time because it’s winter and, well, it’s snowing outside.

What’s a buyer to do? In this scenario, an escrow holdback could be a path to funding the necessary repairs without blowing your closing date. Here, you’ll learn more about escrow holdbacks, including:

•   What is an escrow holdback?

•   How does an escrow holdback work?

•   What qualifies for an escrow holdback?

•   What if your situation doesn’t qualify for a holdback?

Escrow Holdbacks Defined

Before defining escrow holdbacks, here’s what escrow is: Typically, it’s money held by a third party as assets (such as real estate) are being transferred.

An escrow holdback agreement, however, occurs when money is set aside at the closing of a home to complete repairs. Generally, the seller is the one supplying the money, though not always.

Money is held in an escrow account until the repairs are completed. The funds can then be released. Another name for an escrow holdback that you may hear used is a repair escrow.

This may sound like a pretty good arrangement, but an escrow holdback isn’t a possibility for every borrower and in every scenario. Consider the following:

•   The lender’s underwriter will review the appraisal and any accompanying inspection reports to confirm that the sales price is met and that the property does not show evidence of any deferred maintenance items that can have an effect on things like safety, soundness, or structural integrity.

•   These are often referred to as health and safety issues. Health and safety issues can affect whether the home is eligible for financing.

•   Most lenders will not close a loan on a home that has been called out for things like missing railing, stairs, fencing, and much more.

It’s not hard to imagine a situation where a homebuyer needs the seller to repair something that cannot be completed until after the contract’s closing date, as in the snowstorm example above. Depending upon the repair, a lender may allow for the seller to place a specific amount of funds in escrow for what’s known as defect cure, which must be completed within a specified period of time.

These repairs could be expected or unexpected as the parties move through the homebuying process. Generally, the appraiser calls out the more obvious issues that hurt a home appraisal and may recommend further inspection by an expert for something noted in their report. If an appraiser requests an inspection, the lender’s underwriter may review the report and require some repairs.

Another example of a situation in which an escrow holdback could be a valuable tool: when a seller needs the proceeds from the sale of the home in order to comply with the repair request.

These are examples of how and when an escrow holdback could be warranted and beneficial. If you’ve never been through the homebuying process before and all this is making you a bit nervous, consult a first-time homebuyer’s guide for help.

Recommended: 31 Ways to Save for a Home

How Does the Escrow Holdback Process Work?

If you’re curious about how the escrow holdback process works, consider these points that spell out the process in more detail:

•   Normally, the first step is the buyer’s and seller’s agents negotiating any required repairs through an addendum to the purchase contract. This is drawn up by the real estate agents and signed by all parties.

•   The document will likely outline the repairs that the buyer (or lender) would like the seller to make, the timeframe for those repairs, and details about how and when the payments to the contractors are to be made.

•   This contract addendum is then sent to the escrow company (or the attorney) and to the lender, who will review the document. The underwriter of the loan will have the last say as to whether the escrow holdback is approved.

•   If it is approved, then the closing may proceed as initially planned. However, not all holdback requests will be approved. The lender may have conditions around the approval of an escrow holdback. These can include but are not limited to such requirements as improvements having to be completed within 180 days of the mortgage closing date.

   The lender may have conditions around the approval of an escrow holdback. These can include but are not limited to such requirements as improvements having to be completed within 180 days of the mortgage closing date.

•   The lender will likely establish an escrow completion account with the title company from the purchase proceeds. This is typically equal to 120% of the estimated cost for completing the improvements and more.

•   Once the repairs are completed, another inspection occurs to verify that the work has been satisfactorily finished. The escrow account can then release the funds.

It’s important to note that not all transactions qualify for an escrow holdback. The criteria can vary between lenders, property, and even type of transaction (sale of existing property or of a new construction home).

Recommended: What to Look for When Buying a House

What Qualifies for an Escrow Holdback?

Generally, lenders prefer that repairs take place prior to the closing, but exceptions can be made — such as when repairs must be delayed due to inclement weather.

This may limit escrow holdbacks to repairs that require some work on the outside of the home, such as repairs to a roof, yard, or plumbing accessed outdoors.

Here are some types of repairs that are factors that affect property value and residents’ safety and may qualify for an escrow holdback. These are probably already on your list of things to look for when buying a house:

•   Patio problems

•   Pest control

•   Roof repair

•   Septic tank issues

•   Sprinkler system problems

•   Yard cleanup

Again, there are no sure things or guarantees of how an escrow holdback will work. That’s because it is ultimately up to all of the involved parties to agree on the terms.

Beyond the weather causing a delay, lenders are often looking to determine whether the repairs present a risk to the property (their collateral) or present health and safety issues to the prospective occupants. As you might imagine, a lender generally won’t want to make a loan for a property that they believe could threaten the health or safety of its occupants.

Recommended: The 7 Steps to Buying a House

What if Your Situation Doesn’t Qualify for a Holdback?

Say you believe there is an issue that merits an escrow holdback, but the lender doesn’t approve it. Now what? There’s not much, unfortunately, that you can do in this situation. The most likely scenario is that the closing date will need to be pushed out to make time for any required repairs before loan closing.

As you pursue an escrow holdback, it might be helpful to understand that some lenders’ guidelines may not offer escrow holdbacks under any conditions.

This could be due to the fact that the follow-up involved in closing the holdback is too arduous. Or perhaps there are difficulties in getting the repairs completed within the specified period of time given. If lenders have been burned in any of these ways in the past, they may decide the process is too risky.

In the event that a lender refuses an escrow holdback agreement, you might have to delay your closing. If the lender also refuses to make a loan, you (the buyer) could be in a very tough spot. Even if you’re willing to pay for the cost of repairs in order to move forward with the lending process, this may not be in your best interest.
You do not yet own the property, and issues can arise from financing repairs to it.

It may be wise to get your real estate lawyer’s and real estate agent’s opinions about how to handle this kind of difficult situation. They can help you explore any options that exist.

The Takeaway

Escrow holdbacks can be a way to solve for needed repairs of a property you are interested in buying or have already begun to purchase. By keeping funds in this kind of account, the parties involved may be able to satisfactorily complete the work needed and pay for it in a clear and equitable way.

No matter your situation, you’ll likely want to work with a lender that can help you navigate the home-buying process. While you’re shopping for a mortgage, check out customer service reviews in addition to rates and terms.

Looking for an affordable option for a home mortgage loan? SoFi can help: We offer low down payments (as little as 3% - 5%*) with our competitive and flexible home mortgage loans. Plus, applying is extra convenient: It's online, with access to one-on-one help.

FAQ

Is a deposit different from a holdback?

A deposit and a holdback are not the same thing in real estate, although both may be held in escrow (which means they are held by a third party in the transaction). A deposit is money provided by the buyer early in the sale process to show the seller that they are interested in proceeding in good faith with the purchase of a property. A holdback is typically provided by the seller near the closing of the deal. In this case, funds are held back (in escrow) to pay for a repair to the property that needs to be done within a certain period of time after the closing.

What is a release of escrow holdback?

If funds have been withheld to pay for repairs, an inspection will be done to confirm the repairs are completed. At that point, if repairs are satisfactory, the escrow holder will release the funds to pay for the repair; any remaining funds are typically returned to the seller.

SoFi Loan Products
SoFi loans are originated by SoFi Bank, N.A., NMLS #696891 (Member FDIC). For additional product-specific legal and licensing information, see SoFi.com/legal. Equal Housing Lender.

SoFi Mortgages
Terms, conditions, and state restrictions apply. Not all products are available in all states. See SoFi.com/eligibility-criteria for more information.

*SoFi requires Private Mortgage Insurance (PMI) for conforming home loans with a loan-to-value (LTV) ratio greater than 80%. As little as 3% down payments are for qualifying first-time homebuyers only. 5% minimum applies to other borrowers. Other loan types may require different fees or insurance (e.g., VA funding fee, FHA Mortgage Insurance Premiums, etc.). Loan requirements may vary depending on your down payment amount, and minimum down payment varies by loan type.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

This article is not intended to be legal advice. Please consult an attorney for advice.

This content is provided for informational and educational purposes only and should not be construed as financial advice.

SOHL-Q424-140

If you’ve applied for federal student loans in the past, chances are you’re familiar with the Expected Family Contribution, or EFC — a number used by colleges to figure out how much financial aid students are eligible for.

Starting in the 2024-2025 school year, the EFC was replaced by the Student Aid Index, or SAI. It fulfills the same basic purpose but works a little differently, which we’ll discuss in-depth below.

This change was part of the larger FAFSA® Simplification Act, which itself was part of the larger Consolidated Appropriations Act passed in December 2020. The idea is to simplify the federal aid application process by making it more straightforward for students and their families, particularly for lower-income earners. But all changes come with a bit of a learning curve, even if simplicity is the goal. Here’s some helpful information about the Student Aid Index.

Student Aid Index vs the Expected Family Contribution (EFC)

While both of these calculations perform a similar function, there are important differences in how they work—and important ramifications on how students receive financial aid.

How the EFC Currently Works

Despite its name, the Expected Family Contribution is not actually the amount of money a student’s family is expected to contribute—a point of confusion Student Aid Index is meant to clarify.

Rather, the EFC assesses the student’s family’s available financial assets, including income, savings, investments, benefits, and more, in order to determine the student’s financial need, which in turn is used to help qualify students for certain forms of student aid, including Pell Grants, Direct Subsidized Loans, and federal work-study.

A very simplified version of the calculation looks like this:

Cost of college attendance – EFC = Financial Need

However, a college is not obligated to meet your full financial need, and they may include interest-bearing loans, which require repayment, as part of a student’s financial aid package.

Still, the EFC plays an important role in determining how much financial aid you’re eligible for and which types.

How Does the Student Aid Index Work?

The Student Aid Index works in much the same way: the figure will be subtracted from the cost of attendance to determine how much need-based financial aid a student is eligible for. However, there are some important updates that come along the rebranding:

Pell Grant Eligibility

Pell Grant eligibility is determined primarily by a student’s SAI, which measures financial need based on information provided in the FAFSA. Unlike the EFC, the SAI can go as low as -$1,500, helping to identify students with the highest need. Students with lower SAIs are more likely to qualify for Pell Grants, which are awarded to low-income undergraduate students to help cover educational expenses.
Eligibility also depends on factors like enrollment status, the cost of attendance, and federal guidelines. The SAI provides a clearer, more equitable assessment of financial need for Pell Grant allocation.

New Rules

The SAI comes along with new rules that allow financial aid administrators to make case-by-case adjustments to students’ financial aid calculations under special circumstances, such as a major recent change in income. The bill also reduces the number of questions on the FAFSA down to a maximum of 36 (formerly 108), removes questions about drug-related convictions (which can now disqualify applicants from receiving federal aid), and more.

Recommended: How to Complete the FAFSA Step by Step

How Will the Student Aid Index Be Calculated?

The Student Aid Index will be calculated much the same as the Expected Family Contribution is calculated today, though the bill does include some updates to make the process easier.

For one thing, the bill works together with the Fostering Undergraduate Talent by Unlocking Resources for Education (FUTURE) Act to import income directly into a student’s FAFSA, simplifying the application process.

The new FAFSA will also automatically calculate whether or not a student’s assets need to be factored into the eligibility calculation, shortening the overall application and offering more students the opportunity to apply without having their assets considered.

The bill also removes the requirement that students register for the Selective Service in order to be eligible to receive need-based federal student aid.

Recommended: Getting Financial Aid When Your Parents Make Too Much

What Is a Good Student Aid Index Score?

The Student Aid Index isn’t like a test or a report card — there aren’t really “good” or “bad” scores, or “scores” at all. It just depends on your personal financial landscape.

But just like the EFC, the lower the SAI, the more need-based aid a student may be qualified for. Since need-based aid includes grants, which don’t need to be repaid, and subsidized loans, whose interest is covered by Uncle Sam while you’re attending school, a lower SAI may translate into a lower overall college price tag.

Recommended: Private Student Loans vs Federal Student Loans

How Will the Student Aid Index Be Used?

Like the EFC before it, the SAI is used to help colleges determine a student’s financial need based on their financial demographics. Although the school itself may have its own grant programs and other types of aid, certain forms of federal student aid — such as Pell Grants and Direct Subsidized Loans — are offered based on demonstrable financial need, and the SAI is a key part of the calculation used to determine that need.

In short: the SAI will be used to determine how much financial aid a student is eligible to receive.

When Did the SAI Go Into Effect?

The SAI was implemented in the 2024-2025 academic year.

The Takeaway

The Student Aid Index is essentially the same number as the Expected Family Contribution, but it’s been renamed as part of the FAFSA Simplification Act in order to clarify to families what exactly the number means. This act also bundles in some other important changes that will hopefully simplify the overall student loan application process and increase access to education for the lowest-income students and their families.

If you’ve exhausted all federal student aid options, no-fee private student loans from SoFi can help you pay for school. The online application process is easy, and you can see rates and terms in just minutes. Repayment plans are flexible, so you can find an option that works for your financial plan and budget.

FAQ

What is the Student Aid Index?

The Student Aid Index (SAI) is a measure used to determine a student’s eligibility for federal financial aid. It replaced the Expected Family Contribution (EFC) starting in the 2024-2025 academic year. The SAI assesses a family’s financial situation to calculate the amount of need-based aid a student may qualify for.

How is the Student Aid Index calculated?

The SAI is calculated using financial information from the FAFSA, including family income, assets, and household size. Unlike the EFC, the SAI can be a negative number, which helps identify students with the highest financial need.

Why was the SAI introduced?

The SAI was introduced to improve clarity and fairness in the financial aid process. By allowing for a negative value, it better reflects the financial need of students from low-income families. The change aims to make financial aid distribution more equitable and easier to understand for students and families.

Photo credit: iStock/SDI Productions

SoFi Private Student Loans
Please borrow responsibly. SoFi Private Student loans are not a substitute for federal loans, grants, and work-study programs. We encourage you to evaluate all your federal student aid options before you consider any private loans, including ours. Read our FAQs.

Terms and Conditions Apply. SOFI RESERVES THE RIGHT TO MODIFY OR DISCONTINUE PRODUCTS AND BENEFITS AT ANY TIME WITHOUT NOTICE. SoFi Private Student loans are subject to program terms and restrictions, such as completion of a loan application and self-certification form, verification of application information, the student's at least half-time enrollment in a degree program at a SoFi-participating school, and, if applicable, a co-signer. In addition, borrowers must be U.S. citizens or other eligible status, be residing in the U.S., and must meet SoFi’s underwriting requirements, including verification of sufficient income to support your ability to repay. Minimum loan amount is $1,000. See SoFi.com/eligibility for more information. Lowest rates reserved for the most creditworthy borrowers. SoFi reserves the right to modify eligibility criteria at any time. This information is subject to change. This information is current as of 04/24/2024 and is subject to change. SoFi Private Student loans are originated by SoFi Bank, N.A. Member FDIC. NMLS #696891. (www.nmlsconsumeraccess.org).

SoFi Loan Products
SoFi loans are originated by SoFi Bank, N.A., NMLS #696891 (Member FDIC). For additional product-specific legal and licensing information, see SoFi.com/legal. Equal Housing Lender.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

SOISL-Q424-061

The impact of interest rates and their fluctuations are a fact of life for investors, and there are several ways interest rates can affect the stock market. For example, higher interest rates raise the cost of borrowing for consumers and corporations, which can ultimately affect public companies’ earnings, and potentially, stock prices. The reality for stock market investors is that even minor adjustments to interest rates can significantly impact their portfolios.

But the effects interest rates may have on stock prices goes much deeper than that. Here’s how rising or falling interest rates could affect stocks, stock prices, and the stock markets.

What’s the Fed Fund Rate?

While many market factors come into play to determine interest rates, the Federal Reserve, or the U.S. central bank, influences rates and sets the fed funds rate. The fed funds rate is the rate that financial institutions trade federal funds, which has a downstream effect on interest rates of all types, from mortgage rates to the effective interest rate you’ll pay on your credit card balance.

Zooming out even more to try and get more context, the Fed has a “dual mandate”:

•  Create the best environment for maximum employment.

•  Stabilize prices, or keep inflation in check.

One of the tools the Fed has in its toolkit to try to achieve these twin goals is controlling short-term interest rates — or, the Fed Funds rate. This is done by the Federal Open Market Committee (FOMC) — made up of 12 Fed officials — which meets eight times a year to set the federal funds rate, or the target interest rate.

The federal funds rate is the rate banks charge each other to lend funds overnight.

Other factors influence general interest rates, like consumers’ demand for Treasuries, mortgages, and other loans. But when the Fed adjusts the federal funds rate, it has sweeping ripple effects on the economy by broadly changing the cost of borrowing.

When Rates Go Up, What Happens to the Stock Market?

The Fed may increase interest rates in response to some macroeconomic trend, such as rising prices (or inflation). That was the case in 2022 and 2023, when the Fed increased interest rates in response to rising inflation. That’s generally a sign that the economy is a bit too hot, or growing too fast.

If the U.S. economy is growing too fast, the Fed can hike interest rates to get a grip on rising inflation – again, which is exactly what happened in 2022 and 2023 – which effectively makes goods and services more expensive. This is to make borrowing and getting credit more expensive, which curbs consumer and business spending, reduces widespread prices, and hopefully gets the economy back on an even keel.

Another example: In the early 1980s, Fed Chair Paul Volcker jacked up interest rates to above 20% in order to tame runaway inflation; prices were rising by more than 10% annually during the period. Volcker’s interest rate moves were a big reason why the average 30-year mortgage rate was above 18% in 1981.

As for how that affects the stock market? Generally, it leads to a decline, though not always. Since costs go up after a rate hike, earnings can fall, and investor sentiment can take a hit, too.

When Rates Go Down, What Happens to the Stock Market?

Conversely, when rates go down, the market may rally, as the Fed is signaling that it wants to give the economy a shot in the arm. That means borrowing costs could decline, more people could potentially be spending money, and businesses could drive more revenue and profits. Those are all things investors want to see and hear, so they may increase demand for stocks, lifting the market overall.

Again, the Fed might do this if it thinks the economy is too slow or contracting, and wants to boost activity. This move, known as loose monetary policy, is one way the Fed attempts to hit the mandate of creating the best environment for maximum employment.

In short: Lower interest rates make it easier for consumers, businesses, and other economic participants to borrow money and get easier access to credit. When credit flows, Americans are more likely to spend money, create more jobs, and more money enters the financial markets.

Recent history bears this strategy out. In 2008, when the global economy cratered, and both employment and spending were in free fall, the Fed slashed rates to near zero percent to make credit easier to get and restore confidence among consumers and businesses that the economy would stabilize. The Fed again cut interest rates in March 2020 to near zero percent to stimulate the economy during the initial waves of shutdowns due to the coronavirus pandemic.

Do Rate Changes Impact the Bond Market?

Generally, higher interest rates tend to be a headwind for stocks, partly because investors will prefer to invest in lower-risk assets like bonds that may offer an attractive yield in a high-interest rate environment.

But lower rates may make the stock market more attractive to investors looking to maximize growth. Because investors cannot get an attractive yield from lower-risk bonds in a low rate environment, they will put money into higher-risk assets like growth stocks to seek an ideal return. So, there tends to be an inverse relationship between stocks and bonds depending on the prevailing interest rate environment.

Recommended: Bonds vs. Stocks: Understanding the Difference

Other Areas Affected by Rate Changes

While the stock market may be affected by rate changes, so are consumers and businesses.

Consumers

In a period of high interest rates, publicly traded companies face a potential indirect threat to revenues, which could hurt stock prices.

That’s due to the reduced levels of disposable income in a high-rate environment. Higher rates make it more expensive for consumers to borrow money with credit cards, mortgages, or personal or small-business loans.

Consumers’ tighter grip on their pocketbooks may negatively affect companies, who find it more challenging to sell their products and services. With lower revenues, companies can’t reinvest in the company and may experience reduced earnings.

Companies

Businesses that are publicly traded can experience significant volatility depending on interest rate fluctuations. For instance, changes in interest rates can impact companies through bank loan availability.

When rates rise, companies may find it more difficult to borrow money, as higher interest rates make bank loans more expensive. As companies require capital to keep the lights on and products rolling, higher rates may slow capital borrowing, which can negatively impact productivity, cut revenues, and curb stock growth.

Correspondingly, companies can borrow money more freely in a lower interest rate environment, which puts them in a better position to raise capital, improve company profitability, and attract investors to buy their stock.

Protecting Your Investments From Higher Rates

There are strategies you can use to protect your portfolio when interest rates change.

•   Monitor the Federal Reserve and its rates policy. The FOMC meets eight times a year to discuss economic policy strategy. Even if they don’t result in an interest rate change, announcements from the meetings can significantly impact the stock market.

•   Diversify your portfolio. Investors can try to diversify their portfolio up front. A portfolio with a mix of investments like stocks, bonds, real estate, commodities, and cash, for example, may be less sensitive to interest rate moves, thus minimizing the impact of any volatile interest rate fluctuations.

•   Look into TIPS. Investing in Treasury Inflation Protected Securities (TIPS) may help fortify a portfolio against interest rate swings. TIPS are a form of Treasury bonds that are indexed to inflation. As inflation rises, TIPS tend to rise. When deflation is in play, TIPS are more likely to decrease.

The Takeaway

Changes in interest rates can have far-reaching effects on the stock market. In general, higher interest rates tend to have a dampening impact on stocks, while lower interest rates tend to boost market prices. Higher interest rates effectively mean higher borrowing costs that can slow down the economy and companies’ balance sheets and drag down stock prices. Additionally, higher interest rates can boost the appeal of bonds relative to equities, which also acts as a drag on stocks.

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FAQ

How do rate changes affect stock prices?

Rate changes can and do affect stock prices. Typically, when rates rise, the market falls, and conversely, when rates fall, the market rises.

What sectors are impacted the most when rates change?

The financial services industry is one of the most heavily impacted industries when it comes to rate changes, but so are several others, including retail and manufacturing.

How do interest rates affect inflation?

Higher interest rates may serve to lower inflation by reducing overall demand in the economy. Higher rates means higher prices, and fewer people will make purchases accordingly, which should have a downstream effect of lowering prices in response to lower demand.

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