Mortgage rates have been rising and are expected to increase further over the next two years. Home sales and home prices are generally impacted negatively if mortgage rates were the only things changing. Fortunately, there are other economic variables along with the fact that consumers are not tapped out to the maximum in borrowing capacity to suggest home prices will not fall. Prices in fact could grow too fast in one of the scenarios.
A simple mortgage calculation shows a loss of about 12 percent in purchasing power from a one-percentage point rise in mortgage rates. For example, a person taking out a $200,000 using a 30-year fixed rate mortgage at 3.75% rate would have faced $926 monthly payment (just on principal and interest). At 4.75%, and to keep the same monthly payment, the loan amount has to be cut to $177,500. The purchasing power has been reduced due to higher rates.
If everyone wanted to maintain the same mortgage payment as previously planned then one might see a general decline in home values from rising rates in order to accommodate the lower purchasing power. It is unlikely to be an instantaneous price change given the stickiness of home prices but can occur over time as sellers find fewer and fewer buyers without a reduction in prices.
The real world, however, is such that home buyers generally do not quickly scale down the price points knowing that could mean a different neighborhood than what they had envisioned. Rather, people find ways to put additional down payment. Or people stretch their budget and will pay a higher mortgage payment as long as it is manageable. In the current environment, there appears some room to stretch without getting anywhere near the danger zone.
The first graph below shows what a buyer would pay in monthly payment for a median priced home at the prevailing mortgage rates of that time, with a 20 percent down payment. In the most recent data, it was $840 per month. This figure essentially matches the average monthly payment since the turn of the century. With rates rising now that figure is headed up to $920 and possibly $1000 by next year. But it would still be under the danger condition of $1200 during the period of bubble home prices.
There is much talk of stagnant income of the recent times. But the description reflects after accounting for inflation. The raw income figures (or as economists would call it the nominal income) has been rising 1.9 percent a year from 2000. A typical family income was $50,700 in the year 2000. By 2014, the income has grown to $65,300. That means, a family is much more easily able to absorb higher monthly mortgage payment today versus in the year 2000.
A more relevant metric is not monthly payment but monthly payment in relation to income. And the bottom chart shows even a greater possibility to absorb higher mortgage rates. Most recently a typical home buyer was dedicating 15 percent of her income for mortgage principal and interest. To get us to 20 percent, as had been in the year 2000 when there was no concern about home prices being a bubble, mortgage rates would have to rise to about 5.5%. The most weekly mortgage data show rates currently at 4.1%. So there is still a room for rates to rise without damaging housing affordability as compared to historical norms.
Aside from the above number crunching exercise there are many other factors that can influence home values in addition to mortgage rates and people’s income. For example, the London home prices is said to be in housing bubble. But this talk has been ongoing for what seems to be the past few decades. Yet, home prices in London continue to rise. San Francisco home prices are another example. The commonality of these high priced markets is the lack of new home construction. Currently in the U.S., there is an inadequate supply of new home construction. As long as these conditions persist then there is little prospect of home prices tumbling even in a rising interest rate environment. It’s simple supply and demand.
Briefly other factors to suggest home prices would not be impacted from rising mortgage rates are
Higher than normal level of all-cash transactions
Job creating environment and hence low mortgage default rates and consequently few fresh distressed properties.
Large pent-up household formation of many young adults living with parents but just looking ahead to form their own separate households.
Very high stock market valuations, where some people can cash-out portions in order to diversify out of the stock market and put funds into real estate.
The most important variable for home price growth will be new home construction, provided mortgage rates do not rise too fast too quickly. With mortgage rates anticipated to rise to 5.5% by the year-end 2016, home prices will likely change as follows:
Lawrence Yun is Chief Economist and Senior Vice President of Research at NAR. He directs research activity for the association and regularly provides commentary on real estate market trends for its 1 million REALTOR® members.