Recently, Freddie Mac published an Insight Report titled Nowhere to go but up? How increasing mortgage rates could affect housing. The report focused on the impact the projected rise in mortgage rates might have on the housing market this year.
Many believe that an increase in mortgage rates will cause a slowdown in purchases which would, in turn, lead to a fall in house values. Ultimately, however, prices are determined by supply and demand and while rising mortgage rates may slow demand, they also affect supply. From the report:
“For current homeowners, the decision to buy a new home is typically linked to their decision to sell their current home… Because of this link, the financing costs of the existing mortgage are part of the homeowner’s decision of whether and when to move.
Once financing costs for a new mortgage rise above the rate borrowers are paying for their current mortgage, borrowers would have to give up below-market financing to sell their home.
Instead, they may choose to delay both the sale of their existing home and the purchase of a new home to maintain the advantageous financing.”
The Freddie Mac report, in acknowledging this situation, concluded that prices are not adversely impacted by higher mortgage rates. They explained:
“While there is a drop in the demand for homes, there is an associated drop in the supply of homes from the link between the selling and buying decisions. As both supply and demand move together in this way they have offsetting effects on price—lower demand decreases price and lower supply increases price.
They went on to reveal that the Freddie Mac National House Price Index is…
“…unresponsive to movements in interest rates. In the current housing market, the driving force behind the increase in prices is a low supply of both new and existing homes combined with historically low rates. As mortgage rates increase, the demand for home purchases will likely remain strong relative to the constrained supply and continue to put upward pressure on home prices.”
The following graph, based on data from the report, reveals what happened to home prices the last six times mortgage rates rose by at least 1%.
Whether you are a move-up buyer or first-time buyer, waiting to purchase your next home based on the belief that prices will fall because of rising mortgage rates makes no sense.
Nowhere to go but up? How increasing mortgage rates could affect housing
With your interest rates this high high high "How am I ever gunna own what I buy
“My Own Place” by Terri Hendrix
We’re in an era of historically low mortgage interest rates and the expectation is that interest rates have nowhere to go but up. But how quickly will rates increase and how high will they go? If they do rise, what will be the effects on home buyers, homeowners wishing to refinance, mortgage lenders, home builders, and real estate agents? To answer these questions, it’s helpful to review periods when interest rates spiked and analyze the effects, with the hopes of understanding what might happen in the coming years. It’s the next best thing to a crystal ball.
The status quo scenario corresponds to continued expectations of low inflation. Some economists think that a combination of increases in the supply of capital, continued weak aggregate demand for capital, and the slowdown of U.S. productivity growth could lead to an environment of less than full employment, low growth, and low interest rates, sometimes referred to as secular stagnation.7 Under this scenario, mortgage and housing markets would likely plod along, with moderate increases in originations, sales, and starts.
In contrast, the average scenario based on recent history with interest rates rising 146 bps from trough to peak implies a meaningful increase in expected inflation. The most recent low in the 30-year fixed mortgage rate occurred in September 2016, with a monthly average of 3.81 percent. Assuming the average scenario, the 30-year fixed rate would rise above 5.25 percent before declining. The weekly average rate of 4.40 percent, released on February 22, 2018, puts us more than one-third of the way there, as rates have already begun to climb in early 2018. Under this rate scenario, mortgage originations are expected to fall by 30 percent, accompanied by more modest declines in home sales of 5 percent, and a decline in housing construction starts of 11 percent.
Another possibility is that mortgage rates increase for a longer period and remain elevated for an extended period. This could happen if inflation and expectations of future inflation increase.8 The last time there was a sustained increase in rates was from 1977 to 1981. The increase in rates during that period was accompanied by double-digit increases in consumer prices. This severe scenario is estimated by taking the maximum movements during periods of increased rates since 1990. Under this scenario, mortgage rates are expected to increase by 238 basis points, with a 49 percent drop in mortgage origination volume, a 14 percent decrease in home sales, and a 32 percent decline in housing starts.
The specifics of when and by how much mortgage rates move in the near future are still uncertain. However, understanding the incentives of market participants and the historical context informs the expected response of housing and mortgage markets to movements in mortgage rates. Given this context, the expected increase in mortgage rates would suppress growth in the mortgage and housing markets, and lead to declining markets if the increase is large enough or lasts for long enough. But for now, mortgage credit is still historically cheap if you get in while the getting is good.
PREPARED BY THE ECONOMIC & HOUSING RESEARCH GROUP
Doug McManus, Quantitative Analytics Director
Elias Yannopoulos, Quantitative Analytics Senior
1 Higher rates would not increase mortgage payments if house prices fell enough to compensate for the rise in rates.
2 For a rate increase of 100 bps (1 percent) on a $200,000 loan, the value of holding on to below-market financing is at most $2,000 per year of savings in interest payments.
3 Seasonal adjustment is a method that removes predictable seasonal fluctuations in the data. The strong seasonality in mortgage activity makes it hard to draw comparisons month-to-month without some adjustment.
4 An exception is 1996, when the rate increase was short lived and had only a small impact on origination volume.
5 Typically, borrowers making a down payment of less than 20 percent of the purchase price of the home will need to pay for mortgage insurance. FHA loans require mortgage insurance payments even if the balance falls below 80 percent of the home value, but these loans can be refinanced without mortgage insurance.
6 This is not true for adjustable rate mortgages, which are closely linked to short-term interest rates.
7 See former Fed Vice Chairman Stanley Fischer’s October 2016 speech at the Economic Club of New York (“Why Are Interest Rates So Low? Causes and Implications,” https://www.federalreserve.gov/newsevents/speech/fischer20161017a.htm), and the 2016 IMF Mundell-Fleming Lecture by former Treasury Secretary Lawrence H. Summers (“Macroeconomic Policy and Secular Stagnation”).
8 Esther George, president of the Kansas City Federal Reserve, has warned that too much accommodation runs the risk of overheating the economy, which could put in motion an undesirable increase in inflation. See “Monetary Policy in a Low Inflation Economy,” https://www.kansascityfed.org/~/media/files/publicat/speeches/2017/2017-george-centralexchange-10-11.pdf.