Will Rising Mortgage Interest Rates Kill Home Prices?

Mortgage interest rates have been on the rise lately, which will make it more expensive to buy a home. This raises a question of what impact this could have on home prices: will the added interest expense of higher rates choke off demand and kill the recent rally in housing?

While that’s an understandable concern, history suggest sthere might be an X factor at work that would bail out home prices.

Recent Conditions

After a prolonged slump, housing prices have started to recover over the past year. The S&P/Case-Shiller 10-City Composite is up 11.6 percent for the most recent 12-month period, culminating in its best month ever in April.

However, while the most recent housing figures measure prices through the end of April, what has happened to mortgage interest rates since then is significant. According to mortgage finance company Freddie Mac, 30-year mortgage rates have risen by more than a full percentage point since then. So, it remains to be seen whether the rally in home prices can survive this rise in mortgage interest rates.

3 Ways to Look at the Problem

Here are three ways you can think about the impact of rising interest rates on home prices:

1. A budgeted payment approach. Imagine you have budgeted $1,500 for your monthly mortgage payment. Using a mortgage calculator, you would find that this would mean you could afford about a $247,000 loan at a 3.5 percent 30-year mortgage rate. Now bump that mortgage rate up to 4.5 percent – you’d find that the same payment would allow for a loan of about $225,000. That’s a reduction of nearly 9 percent. Assuming this micro example is typical of the impact higher rates would have on the money available to spend on housing, you could reasonably expect higher mortgage interest rates to force housing prices lower.

2. Demand-driven impact. Another way to think about it is from the point of view of demand for housing. Lower mortgage interest rates were intended to attract people back to the housing market after prices collapsed in 2007 and 2008. Logically then, higher rates would start to discourage some of that demand, and weaker demand usually means lower prices.

3. A contrary history. Although there are good reasons to suspect that higher mortgage interest rates would put downward pressure on housing prices, history indicates that things don’t work out that way. There are 25 full calendar years of history for the Case-Shiller 10-City Composite. The average annual price change for those 25 years is an increase of 3.69 percent. Looking at the price change in different mortgage rate environments produces some interesting results. When mortgage rates were essentially flat for the year (with a change of less than half a percent up or down), home prices averaged an increase of 3.66 percent. Not surprisingly then, when interest rates were more or less neutral, the change in home prices roughly matched the long-term average increase. However, years when mortgage rates fell by half a percent or more produced a substandard gain in housing prices on average – just 1.38 percent. On the other hand, in the few years (there have been just three of them) when rates rose by half a percent or more, the housing market averaged a healthy 9.47 percent gain.

The X Factor

So how do you reconcile the contradiction between the logic that higher rates should be a drag on housing prices and a history which suggests that the opposite is true? The answer is that there is more at work on housing prices than just mortgage interest rates – there is an X factor.

That X factor is the strength of the economy. According to the Bureau of Economic Statistics, real GDP growth in the three years when mortgage rates rose by more than half a percent averaged 4.0 percent. For the 25-year period overall, annual real GDP growth averaged just 2.5 percent. In other words, those rising mortgage rate years were marked by above-average economic growth, which no doubt helped fuel demand for housing.

Although the economy is not yet growing at anything close to a four percent annual rate, that X factor does tie into the current situation. Mortgage rates have started to rise in anticipation that the Federal Reserve will scale back its intervention as the economy improves. In other words, the silver lining here is that mortgage rates are rising on the premise that the economy is gaining momentum.

History shows that housing prices can withstand a rise in mortgage interest rates, thanks to the added support of economic growth. Therefore, the silver lining behind those rising rates has been that consumers were in a better financial condition due to a stronger economy. What history doesn’t tell us is what would happen to housing prices if rates rise and economic growth fails to come through. That lose-lose scenario hasn’t happened yet, but the economy is still on shaky enough ground that 2013 could be a first.

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