Higher mortgage interest rates lead to lower sales or lower prices
In the absence of rising wages, when mortgage interest rates go up, one of two things will happen: either sales will fall, or prices will fall. Since we don’t have a free market in housing, sales will fall and remain depressed for a very long time.
Assuming a consistent payment, higher mortgage rates decrease the size of the loan and reduce the amount borrowers can bid on real estate. While it is possible the federal reserve may print enough money to spark wage inflation, given the high levels of residual unemployment and a low labor participation rate, wage inflation is a long way off, almost certain to come later than rising mortgage rates. Therefore, if rising mortgage rates results in smaller loan balances, then either sales volumes will go down, or house prices will go down, or perhaps some combination of both. This isn’t speculation; it’s basic math.
So which outcome seems more likely? If we had a free market without government and lender manipulation, prices would fall, perhaps precipitously depending on the market; however, we don’t have a free market, and our government, federal reserve, and a cartel of too-big-too-fail lenders are manipulating the housing market in an effort to drive up house prices. Since must-sell shadow inventory morphed into can’t-sell cloud inventory, I think it likely that home sales will be depressed for several years. If we had cleared the market, hedge funds and other investors would have purchased millions of homes, and sales volumes would have been much higher. Of course, this would have bankrupted the banks, so another path was taken, but this path has consequences. If the plan is to sell these homes to owner-occupants and higher prices — a group struggling with high unemployment, low savings, high debt levels, and poor credit scores — then it’s going to be a long, slow slog.
Record declines in home prices are a big reason housing turnover has been so muted in recent years, but low interest rates could serve as an additional — and underappreciated — contributor to the depressed level of homes being offered for sale, according to a forthcoming paper from researchers at DePaul University.
As interest rates begin to rise from their record lows of the past two years, more homeowners with a 3.5% rate will find it less appealing to sell their home when faced with buying their next one at, say, a 5.5% or 6% rate.
This isn’t a matter of “appeal,” it’s a matter of affordability.
There are a number of hidden assumptions in the study’s authors’ conclusions. First, the authors assume a person currently borrowing at 3.5% can afford to borrow the same amount at 5.5%. Since most people borrow the max when buying a house (at least in California), then if mortgage rates rise to 5.5%, they won’t be able to borrow near as much money. Assuming prices remain constant, they simply won’t be able to afford to buy another home — which leads to the second hidden assumption, house prices will remain constant.
If mortgage interest rates rise to 5.5%, future buyers won’t be able to finance such large loans; therefore, they won’t be able to buy out today’s buyers allowing them to make a move-up purchase, or if they do execute a sale, it will be at a lower price, and the owner will obtain less equity (or none at all). Without the additional equity from a future sale, the people who own today won’t be able to leverage into a move-up home tomorrow at higher interest rates.
The authors of this study ignore these hidden assumptions and assume future buyers are motivated by the “appeal” of these additional costs without examining the hard facts about equity and leverage and how affordability limits sales.
Millions of homeowners could face so-called “lock in” from low interest rates, especially if rates rise sharply in the coming years, potentially curbing housing demand.
The American economy remains particularly exposed to this risk because of the popularity of fixed-rate mortgages, which also shield borrowers, of course, from higher payments during a rising interest rate environment.
The fact that so many borrowers used fixed-rate mortgages is the only reason these properties won’t be forced on the market in distressed sales. At least the owners with fixed-rate mortgages can afford their payments and stay put. The people borrowing with ARMs are the ones who will find their house payments increasing so much they are forced to sell. Fixed-rate mortgages contribute to the stability of the housing market by limiting distressed sales, and that’s a good thing.
The potential for lock-in arises because homeowners that refinanced at ultralow interest rates face a “higher payment on the same mortgage amount,” says Geoff Smith, director of the Institute for Housing Studies at DePaul University in Chicago. “You’d think that would be a disincentive to trade up or to move in some cases.”
DePaul researchers Patric Hendershott, Jin Man Lee and James Shilling looked at mortgages outstanding between 2005 to 2011 in Cook County, Ill., which includes Chicago. Their simulation modeled a one percent increase in interest rates in each of the coming three years, along with a 10% increase in home prices.
The two assumptions can’t happen together: if interest rates to up significantly, prices won’t also go up unless incomes rise rapidly allowing borrowers to finance larger sums, and rapid wage increases simply isn’t going to happen.
The result? Even though rising prices will free more “underwater” homeowners, or those who owe more than their homes are worth, to list their homes for sale, it wouldn’t be enough to offset the potential number of households who don’t want to sell because they’d have to trade up to a much higher interest rate.
The research found that a three percentage point increase in rates over three years would reduce housing turnover by 75%….
Because interest rates have mostly drifted lower over the past 30 years, the U.S. economy doesn’t have any recent experience with the potential side-effect of rate lock-in. But research indicates that when rates on the 30-year fixed-rate mortgage rose from 10.1% to 17.8% between 1978 and 1981, household mobility fell 15% for every two percentage point increase in rates, according to research published by John M. Quigley of the University of California, Berkeley.
This has nothing to do with the potential side-effects of rate lock-in. The problem is and always was affordability, and the long-term decline in mortgage rates has artificially improved affordability. (See: Housing market impact of 25 years of falling mortgage interest rates)
For example, the average monthly interest rate from 1993 to 1999 was 7.63%. The average monthly cost of ownership was $1,538. That combination would finance a loan of $223,011. Add a 20% down payment, and the home price would be about $275,000 ($278,763 to be exact). Over the last 12 months, the median monthly cost of ownership in OC was $2,102. If you plug in that number in place of the $1,538 from 1993-1999, the resulting home price would be $380,089. The last reported median home price for OC was just over $500,000. House prices have been boosted about 30% due purely to the decline of interest rates from the mid 90s to today.
So now let’s assume mortgage rates will revert to the mean. What will a long-term rise in interest rates do to home prices? Interest rates must rise from about 4.5% to 7% to reach historic norms. If this happens over a 7 year period — which is a very gentle rise — rental parity will still fall from its current level even as rents and fundamental values rise. Since rental parity will serve as a more rigid ceiling on appreciation in the future, when prices rise beyond this barrier, it will serve as a major drag on appreciation.
In the absence of rising wages, when mortgage interest rates go up, one of two things will happen: either sales will fall, or prices will fall. Since we don’t have a free market, it seems more likely to me that sales will fall and remain depressed for a very long time.