Are today’s homebuyers considering the impact of rising mortgage rates?

Buyers convince themselves rising mortgage rates won’t impact them, but they fail to consider how rising rates will curb home price appreciation.

real_estate_always_goes_upI strive to educate this blog’s many readers and dispel fallacies surrounding residential real estate. Sometimes, the public impresses me with their wisdom; For example, adjustable-rate mortgage use is very low despite the potential savings. However, when it comes to the impact of rising mortgage rates on housing, people prefer to stick their heads in the sand and hope for the best.

Homebuyers consume Kool-aid with respect to their Coastal California home purchases. The bust is only four years behind us, but people already comment on how buying houses in Coastal California is the smartest investment someone can make. Many believe house prices could never go down again, or if they did, the recovery would be speedy. Perhaps past history justifies this smug assurance, or perhaps the powers-that-be exhausted every possible prop and manipulation, and they would be powerless against another bear market.

Most of the kool-aid intoxicated bought their homes because despite paying sky-high prices, they believe house prices can rise much, much higher. Irrespective of whether or not house prices ever fall, it’s unlikely house prices will rise as far or as fast as most of these investors believe. In some respects, this misplaced faith in rapid home price appreciation resembles 2006.



Mortgage interest rates averaged less than 4% over the last 5 years, and many people believe this aberration is normal. Most people assume that either mortgage interest rates will remain low forever, or if rates rise, it won’t impact housing. While I agree that mortgage interest rates will likely remain very low for a very long time, I believe this because the impact of rising rates on housing would be huge, so it simply won’t be allowed to occur.

Belief in permanent, rapid home price appreciation

Homebuyers place too much faith in boundless home price appreciation. In my opinion, this creates four main problems:

  • buyers fail to recognize how much past appreciation was manufactured,
  • buyers neglect to consider their take-out buyer will not be as highly leveraged,
  • buyers underestimate the risk of future downturns, and
  • buyers distort their expectation of future appreciation.

If buyers understood the impact of higher mortgage interest rates, they would make wiser housing decisions.

Past appreciation was manufactured

In the post, Housing market impact of 25 years of falling mortgage interest rates, I documented how falling rates manufactured significant appreciation over the last 25 years, appreciation which would not exist if rates remained flat.

The graph above illustrates the impact of 25 years of falling interest rates. Look carefully at the cost of ownership line. Notice that in 1989-1991, the monthly cost of ownership was about $1,900 per month at the peak of that housing bubble. In 2012, the cost of ownership was less than $1,900 per month. Twenty-four years apart, the cost of ownership on a monthly basis was lower, yet house prices were nearly double. Why is that? Because in 1989, mortgage interest rates were north of 10%, and in 2012, they were 3.5%.

All the appreciation from 1989 to 2012 was a direct result of declining interest rates. All of it.

All of it.

So what would have happened if interest rates hadn’t changed?

Let’s go back to the stable period from 1993 to 1999. The average monthly interest rate during that period 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 were boosted about 30% due purely to the decline of interest rates from the mid-90s to today.

By lowering mortgage rates, the federal reserve pulled-forward seven to ten years of appreciation. The market must endure seven to ten years of below average appreciation to balance the equation, or as a statistician would say, we must revert to the mean.

Take-out buyers will not be as highly leveraged

Back in April of 2007 I first wrote about Your Buyer’s Loan Terms. The future resale value depends on how much future buyers borrow. For future house prices to be higher, future buyers must borrow more than today’s buyers. Ordinarily, future buyers would finance larger mortgages because wage inflation would allow them to make larger payments.

However, for that system to work, mortgage interest rates must be steady or falling. Rising mortgage interest rates cause the borrowing power of future buyers to decline, and if wage growth isn’t strong enough to keep up, then mortgage balances don’t grow larger, and house prices don’t go up. It’s not opinion; it’s math.

Risk of future downturns

Since buyers expect interest rates to remain at or below 5%, they underestimate the risk of future home price declines. Faith in home price appreciation is religion in California, so most homebuyers blithely assume they will sell for a huge profit. But what happens if mortgage interest rates rise faster than wage inflation? Future homebuyers will finance smaller mortgages, and aggregate house prices will be lower than today. Today’s homebuyers are blissfully ignorant to this possibility.

Distorted expectation of future appreciation

Since buyers believe mortgage rates will remain low, and since house prices recently shot up due to low rates and withheld inventory, kool-aid intoxication is taking over. We aren’t seeing the same foolishness as 2005, but most buyers believe house prices will rise significantly, and this believe is prompting them to buy — the precursors to another bubble.

I detailed what might happen in the post 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.

fundamental value anallysis.xlsx


Buyers obviously fail to grasp this concept. Reversion to the mean for mortgage interest rates, should it occur, will weigh on house prices. Wage growth would need to be stellar to compensate. Unless the magic appreciation fairy finds a new mechanism to push prices higher, this cycle of bubble reflation will be shorter than previous real estate rallies.

Despite these limitations, I believe prices will rise over the next few years because buyers with insufficient equity to execute a move-up will restrict inventory keeping prices artificially high.

After a few years, lenders and underwater borrowers will lose control of the supply. Once organic sellers take over, sales volumes should increase, and sales prices will adjust to levels financed buyers can afford. If mortgage interest rates revert to the mean, the market adjusts to this new equilibrium, we will finally reach a state of market normalcy.