What Will Happen In Real Estate When Mortgage Interest Rates Rise
We all know that it is not a matter of "if," but "when?" So what do you think will happen to home values when mortgage interest rates rise?
It's time for you to pick a side and join the great real estate debate.
I have assembled some basic information to share with our readers and it shows that the housing market might be poised for a shift even more dramatic than what occurred when the bubble burst in 2006.
What Will Happen When Mortgage Rates Rise
There is a practice among real estate professionals to correlate a movement in median home prices with real estate appreciation. It is flawed.
Sure, over time, home prices and home values will more likely than not move in the same direction, but to correlate the two over the short-term (meaning for a period of less than five years), one is making a fatal mistake.
Before we compare home prices to home values, we must first look to see if we are comparing "apples to apples." For example, if the median home price is up 6.2% thus far in 2013, are buyers purchasing the same home (specifications) this year as they did last year? Or are they getting more home? Or less home? What if median home prices rise, but median home sizes rise at an even greater rate?
I have always said (and demonstrated) that home prices and values are two very different things, and I think the coming change in mortgage interest rates is going to bring that message home loud and clear. Why?
22 Years Of Homebuyer Behavior
First of all, we have to look at the relationship between mortgage interest rates and homebuyer behavior. Over the past 22 years (my career), roughly 78% of all people who bought a home in Tallahassee financed the home, while 22% paid cash. At a bare minimum, we can safely say that a change in interest rates impacts 78% of all buyers.
As you can see from the mortgage payment table on the left, a rate of 4.19% last month produced a principal and interest payment of $882 for somebody borrowing $190,000 (think of this as a $200,000 homebuyer using a 5% down payment). But look what happens to that payment when rates go up just 2% to 6.19% (a historically very low rate). The monthly payment increases 25%!
You might think that rising or falling loan rates would change the monthly payment that buyers would have to pay, but that has not been my experience. Rather, the relationship is inverted.
The majority of homebuyers who are borrowing money on a house determine a monthly payment with which they are comfortable (or the max a lender will allow), and changing the mortgage interest rate then simply changes how much they will be allowed to borrow.
This means that when mortgage interest rates fall, buyers spend more money. And when rates rise, they spend less money.
The table on the right represents the reality for somebody wanting to keep their monthly mortgage payment below $2000. This would include taxes and insurance (PITI). To simplify the process, our table shows a principal and interest payment of $1500, leaving $500 for taxes, insurance(s), and homeowners fees.
Last month, a borrower could purchase a $323K home with a 5% down payment and a total mortgage payment of $2000. That same buyer can only afford $258K if rates rise 2%, or $65K less.
And look what happens if rates go up to 8.19%, which might sound crazy high but it is lower than the fifty year average (as seen in the graph below). The borrower could then only afford a $211K home, or 35% less than what they could have afforded with October's interest rates.
Historic Mortgage Interest Rates
Take a look at just how low current rates have fallen.
The yellow line in the graph above represents a 50 year average. Do you think that "those days will never return?" Do you really believes that "this time it is different!"?
The Future Of Housing Is Tied To Mortgage Rates
Mortgage interest rates are going to rise again, and the impact on the market could be profound.
Well we know that home affordability is going to drop. Does that mean fewer homes will sell?
Maybe briefly. But ultimately ... No!
People still need to move. They will be spending less money for a home. But the supply of homes is not going to shift to where builders are going to start building a bunch of cheap homes (because they cannot, construction costs have risen). Buyers will simply be spending less money for existing homes and this pressure will be felt hardest at the top end of the market.
We are currently over-supplied with luxury homes for sale in Tallahassee, and the market for these sellers will only get worse as interest rates rise.
Think about how many people can afford a $5000 monthly mortgage payment ($4000 P&I). Well today they can afford to buy a $860K home, but that number drops below $550K when rates return to the fifty year average.
And when rates rise above that average, say to 10%, that same buyer can only buy a $480K home. How many buyers in Tallahassee are going to be comfortable with a monthly payment of more than $5000? Most mortgage lenders will tell you it takes about $200K income per year to handle a $5000 monthly mortgage payment. That is more than four times the median family income in Leon County, so I suspect the number is not very high.
Is there anything happening in our local economy to suggest new job openings that pay above $200K?
I don't think our job growth will be anything comparable to the growth in the number of high end homes that were built over the past 13 years.
That is why our high end homes will face pricing pressure for ten years or longer (until an economy can be created to fill these homes).
And as our larger homes fall in value, the next homes in the food chain will gain new supply (when a $600K home becomes a $550K home, $550K homes gain new competition and stronger pricing pressure).
This compression of the real estate food chain will reach down below $300K, and only with population and economic growth will we finally see a balance return to an overall market where 4% mortgage interest rates are only a folk tale told by ancient real estate agents.