Dec212016

The two main reasons higher interest rates will hurt housing

Higher interest rates reduce housing demand by causing mortgage applications to decline, reducing loan balances, harming employment, and suppressing wages.

permanently_high_plateauThe federal reserve establishes interest rate policy, and for six years, the federal reserve held the benchmark federal funds rate to zero to stimulate the economy. They finally raised rates last December and followed with a second boost this December, the first rate hikes in a decade.

During the period when interest rates were held at zero percent, the federal reserve applied stimulus through a policy known as quantitative easing, a fancy term for printing money. Quantitative easing and mortgage interest rate stimulus were designed to bail out Wall Street, not benefit Main Street.

In 2013 the federal reserve decided to taper housing market stimulus. Now they want to raise the federal funds rate and attempt to move us back to a normal economy with moderate interest rates and no federal reserve stimulus.

Previously, the federal reserve under Ben Bernanke promised to keep a zero percent interest rate until certain benchmarks were met. However, many of Bernanke’s benchmarks came and went with no rate hikes, so the federal reserve under Janet Yellen struggles to establish new benchmarks.

The Federal Reserve issues rosy future guidance and consistently over-estimates the number and timing of future rate hikes. When they raised rates in December, they changed the future guidance from two rate hikes to three for 2017. Realistically, they will probably only increase rates once, twice if the economy is very strong.

Nobody knows when the federal reserve will raise rates, not even the federal reserve, but since higher rates will hurt house prices, we have reasons to believe the federal reserve won’t be raising interest rates very much or very fast.

1. Higher rates equals smaller loans

Assuming a consistent payment, higher mortgage rates decrease the size of the loan and reduce the amount borrowers can bid on real estate. If rising mortgage rates result in smaller loan balances, then either sales volumes will go down, or house prices will go down, or perhaps some combination of both — unless you believe rapid wage inflation is on the horizon.

interest_rate_impact

2. Higher rates lowers home purchase demand

Higher mortgage interest rates lead to lower sales or lower prices, but most likely, lower sales. Mortgage rates fell from mid-2010 through early 2013 just to maintain a low level of demand. When interest rates went up, in what was supposedly a strong market recovery, demand immediately dropped off.

purchase_apps_mortgage_rates_2011-2014

And it isn’t like demand was relatively strong in mid-2010 when it dropped to a 13-year low then stayed there for four years.

MBAApr22014

And this despite a continually rising US population.

Purchase Index and US Population

The problem is affordability. 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.

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 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) 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.

The job market is tightening, and many economists believe wages will start going up more rapidly soon. During the weak recovery of the last two years, wage growth hovered around 2%, well below the 3% norm.

Let’s assume for a moment that the Federal Reserve allows the economy to run hot. Perhaps wage growth will rise to 3% or even 4% before the Federal Reserve removes the punch bowl. It would take 3-4 years of 3%-4% wage growth to compensate for a 1% increase in mortgage rates — and that’s merely a breakeven amount.

Housing undoubtedly faces headwinds.

That being said, yesterday we explored the magnitude of these winds, and I concluded it is probably more a gentle breeze than an equity-evaporating windstorm.