Higher mortgage interest rates will reduce future loan balances; thus today’s homeowners will not experience the home price appreciation enjoyed by previous generations.

Many would-be homeowners rush to the market to lock in low mortgage rates out of fear of being priced out forever. Nervous buyers fear that if they wait, they will fail to get a place of their own. Due to our chronic shortage of homes, there is some basis for this fear, but potential buyers considered the ramifications of that occurrence, the fear would evaporate.

If today’s homebuyer were to be priced out tomorrow, they probably wouldn’t be alone in that predicament. In fact, if a great many people are priced out by rising mortgage rates, by definition, demand declines. Less demand means less home price appreciation or even price drops.

Does that mean that people shouldn’t buy today and wait for a better day? No. In a market where home prices and rents rise in tandem, like ours has for the last four years, residents are equally at risk of being priced out of rental housing or homeownership. Whenever more jobs are created than houses constructed, people bid against one another for the scarce resource, and both rents and home sales prices rise.

The advantage of buying in today’s homebuying environment isn’t future home price appreciation: the advantage is amortization. Low interest rates loan build equity faster in the early years of a mortgage than high interest rates loans. Between the accelerated amortization and freezing housing costs with a fixed rate mortgage, homeownership is still a good financial move even in a low appreciation market environment.

Home Equity

Where does home equity come from? Does it appear by magic, a gift of the appreciation fairy? Does it accumulate by discipline through paying down a mortgage? Both factors are at work, but unless you believe the appreciation fairy listens to your prayers, the only factor that builds home equity you have control over is the amount of debt encumbering the property.

So how does the appreciation fairy work? In concept house prices should rise gently over time to match the growth of wages in the area. In practice house prices rise and fall violently with changes in financing costs, economic upheavals, a downward substitution effect in supply-constrained markets, and kool-aid intoxication, or as economists prefer to call it, animal spirits.

The underlying determinant of home equity is the difference between the resale value and the debt on the property. Resale value is determined by the activity of buyers in the market, and it’s closely tied to the sales prices of comparable properties in the neighborhood.

And what is the largest determinant of the resale price of neighboring homes? The amount the buyer borrowed. In other words, the biggest determinant of your home equity as a homeowner is the amount of debt someone was willing and able to borrow to buy in your neighborhood.

When a property sells for a new high price, the sale impacts values on all similar properties near the new sale. During the housing bubble, neighbors cheered each new higher comp because it added to their (illusory) net worth. With unrestricted access to equity with no-doc loans and 100%+ LTV HELOCs, everyone near a new high comp obtained free money from foolish lenders funded by even more foolish investors.

The late arrivals to the house party eagerly awaited a greater fool to come along and pay an even higher price so they could pilfer their share of the HELOC booty too. Obviously, under such circumstances, the desire for real estate was infinite, and with no impeding lending standards and an eagerness from investors to fund new loans, actual demand as measured by dollars was very high as well; therefore, we ended up with a massive housing bubble.

When the housing bubble collapsed, prudent lending standards returned, and prices dropped precipitously largely because buyers could not borrow the prodigious sums previously made available to them to bid up prices, putting the banks in a bind as the huge reduction in collateral value backed the bad loans they made during the bubble era.

The price collapse put between a quarter and a third of American homeowners underwater, and if the banks were forced to liquidate, it would cause hundreds of billions in losses bankrupting our banking system and triggering a deep economic depression. Something had to give.

The US government and the federal reserve took a number of steps to solve the problem. First, in early 2009, regulators relaxed mark-to-market accounting rules allowing banks to hold bad loans on their books at a fantasy value to avoid loss recognition, buying the banks time. Further, in order to placate pressure from homeowners to “do something” and to provide lenders with a few additional debt service payments on these bad loans, the government embarked on a series of failed loan modification programs.

These were sold to the public as ostensibly helping struggling borrowers, but they were really designed to allow banks to kick-the-can loan-loss recognition and squeeze a few more payments out of hopeless borrowers before they imploded. These programs largely failed homeowners, but succeeded for bankers by providing operating cash while delaying loss recognition for a later equity sale.

Manipulated Mortgage Rates

Ultimately, banks don’t want to recognize losses. They would far rather delay their necessary foreclosures until the loans had collateral backing, allowing them to recover their capital. However, since potential buyers of these properties couldn’t afford to pay an amount which would recover the outstanding debt, the bubble needed to be reflated before the foreclosures could go forward.

To facilitate reflation of the housing bubble, the federal reserve lowered interest rates to zero, and embarked on a program of buying 10-year Treasuries (operation Twist) and directly buying mortgage-backed securities to ensure the flow of capital into the housing market and dramatically lower mortgage interest rates. At the peak of the housing bubble, mortgage interest rates were between 6% and 6.5%. They bottomed out near 3.35% in 2012 — a near 50% reduction. These super-low interest rates gave buyers the ability to borrow amounts commensurate with peak prices under stable loan terms.

Manipulated Supply

Due to the collapse of prices when the housing bubble burst, comparable sales were far below peak prices, and continued foreclosure processing was keeping prices down. The solution was simple; stop foreclosure processing and restrict inventory until the housing bubble reflates.

Lenders stopped foreclosure processing to dry up the inventory, and underwater homeowners patiently wait to list their properties because if they wait, they might escape through an equity sale, avoiding credit problems. With almost no foreclosures or inventory to burden the market, supply is greatly reduced further facilitating a rapid reflation of the housing bubble.

Once the problem of excessive MLS inventory was resolved, we quickly reflated the bubble to allow lenders to recover capital at peak prices, mostly through equity sales, which is where we are today.

Bills Come Due

There is a secret price for the government’s intervention in housing: when rates rise, borrowers will endure reduced borrowing power, home sales volumes decline, resale values may fall, and home equity may be reduced.

Perhaps wages will rise faster than mortgage rates, but it’s unlikely that wages would rise 12% or more to offset the impact of a 1% rise in mortgage rates. In short, future buyers will likely be less leveraged, and although price declines are not certain, rapidly rising house prices seem an unlikely possibility.

So while efforts to reflated the housing bubble succeeded, and both lenders and existing homeowners rejoice in this success, the rising interest rates to come will surprise many homeowners with an unwelcome decade or two of below-average home price appreciation.