Rising interest rates do not boost house prices

Your house is only worth what your buyer can pay for it. Your take-out buyer must be leveraged more aggressively than you are.

One of my earliest posts in May of 2007 was about the impact future loan terms have on future home prices. If interest rates go on a sustained rise, financing home purchases will become more expensive. That is the math. Unfortunately, most people don’t realize this has implications for how much they will be able to sell their house for later on.ownership_is_pain

Most people assume whatever trend was in place in the past will continue indefinitely. Even long-term trends like generally rising home prices for several decades may be the result of underlying factors like falling mortgage rates that may not continue to support the trend. (See: Housing market impact of 25 years of falling mortgage rates)

The real question then is whether or not these rising interest rates are compensated for by rising wages. If wages rise as fast as interest rates do, then borrowers will still be able to finance large sums, and house prices can remain stable or even rise. However, if wages do not rise as interest rates go up, then loan balances will decline, and house prices will fall again.

When people consider buying a house today, they should consider the terms their future take-out buyer will face. This idea is finally gaining attention in the financial media.

Is the Housing Sector Doomed Once Interest Rates Start Rising?

By Matthew Frankel, Dan Caplinger, and Jordan Wathen, March 26, 2015

Most experts and analysts expect the Federal Reserve to start raising interest rates later this year, so how could it affect the housing sector? Sure, mortgage rates will go up with the Fed funds rate, but this doesn’t exactly tell the whole story.

It may not tell the whole story, but rising mortgage rates is the fundamental working against housing over the long term.rising-rates-sales-prices

We asked three of our analysts to give their predictions about what rising rates could mean to housing. Here’s what they had to say:

Matt Frankel: I don’t believe the real estate market is doomed once interest rates start to rise again. Although even a marginally higher interest rate makes a significant difference over the life of a loan, mortgage payments on a monthly basis won’t get that much more expensive when rates begin to rise — at least at first.

Let’s say you want to buy a house and will take out a $200,000 mortgage. With today’s average 30-year mortgage rate of about 3.9%, this would produce a monthly payment of $943. If rates were to increase 0.5% before the end of 2015, it would increase the payment to around $1,000. So while it would be a little more expensive, it won’t make buying a home unaffordable.

Sixty-three dollars out of $1,000 is 6.3%. A wage earner’s income must rise 6.3% to compensate for a 0.5% rise in mortgage rates. That’s no small number despite the implication of his example. A rise of that magnitude will price-out many marginal buyers, and a rise of 1 percentage point will price out twice as many. This glib analysis fails to consider the bigger picture.

Of course, if rates were to spike by, say, three or four full percentage points, it could be a different story, but that’s a highly unlikely scenario.

Interest rate fluctuations are a normal part of a healthy housing market and shouldn’t be feared. In fact, a rate increase is a good indicator that the housing market and overall economy are improving. …

sophisticationWhile that is true, the impact of rising rates will disproportionately be felt in housing because the housing market is extremely sensitive to small changes in mortgage interest rates (See: The housing market depends entirely on interest-rate stimulus)

Dan Caplinger: … I still think the housing sector will have a lot of problems once rates rise. …

In addition, although Matt’s numbers about typical mortgages are correct, they underestimate the impact of even small rate changes in expensive markets where typical mortgage loans are much higher. There, even minimal changes can price out the marginal borrower. Also, rising rates can prevent those who would otherwise choose more efficient options such as 15-year mortgages to have to resort to more traditional 30-year mortgage financing, leaving them with longer periods to repay their debt.

It’s true that because we haven’t seen as much excess in the housing market during this cyclical upturn, the downturn won’t be as severe as the housing crisis was in 2007 and 2008.

I agree. The next housing bust will be a bust in volume, not in price.

Yet rising rates won’t do homeowners any favors, even if they’re inevitable from a market standpoint.

Yes, because homeowners of the future will find it much harder to find a buyer able to leverage themselves so much.

THIS masks a nasty surprise for homebuyers: Zillow

Matthew J. Belvedere, Tuesday, 24 Mar 2015

Extremely low mortgage rates may be putting would-be homebuyers in a tough spot down the road when they’re ready to sell, Zillow Chief Economist Stan Humphries warned on Tuesday.

In a lot of markets, homebuyers are looking at home prices through this artificially distorted lens of very low rates,” Humphries said in a CNBC interview. In other words, they’re willing to pay more because rates are so cheap.

Fast-forward to when current homebuyers want to sell in the future. They might not get that healthy return they were expecting because higher rates tend to put a lid on housing appreciation.

“It’s important for us to get back to a bit more normal rate regime where homeowners are actually looking at the true price of housing … [without] looking at it through 3.5 percent mortgage rates,” he said—

This is one of the clearest statements in the financial media of the point of my post from back in 2007. As I noted back then, “Your house is only worth what your buyer can pay for it. For you to get out at breakeven or better, your take-out buyer must be leveraged more aggressively than you are, or you must wait for fundamental valuations to catch up to today’s pricing.”

What does this mean for the upcoming spring selling season and the rest of the year? Humphries said he’s “cautiously optimistic” about housing in 2015. “The only thing that could improve it would be faster income growth.


What conditions will your future buyer face?

For those who believe California house prices will begin a new phase of sustained rapid appreciation, what conditions will future buyers face that will cause prices to go up so much?

Will interest rates continue to go down?

Will incomes go up substantially?

Will debt-to-income ratio standards be relaxed?

Will future buyers accumulate larger down payments?

One or more of those questions must be answered positively, and any conditions that are contrary to increasing mortgage balances must be offset by gains in other areas for house prices to go up. Appreciation doesn’t happen by magic. House prices must be bid up by future buyers, and based on the conditions I see, now that the market is no longer undervalued and resting at a new equilibrium, future home price appreciation will be tepid at best.


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