of the housing industry, including realtors, home builders, and mortgage
lenders, are virtually unanimous in their conclusion that rising mortgage
rates will not lead to lower prices for residential real estate. This
belief is naturally rooted in self-interest, and fails to account for
a fundamental law of economics which states that supply and demand
determine price. It should be obvious to even the casual observer that
in the real estate market, both supply and demand are greatly influenced
by interest rates.
On the demand side, homebuyers will typically purchase a home based on
the largest monthly mortgage payment for which they have been approved.
If a bank approves a borrower to pay no more than $2,500 per month in
mortgage payments, that borrower could bid a much higher price for a
home if mortgage rates are 5% than if rates were 7%. As an example, with
a 5% rate a buyer might be able to pay $600,000 for a house, but with
a 7% rate that same buyer might only be able to pay $450,000. So the
level of interest rates actually helps form the demand curve. Any increase
in interest rates reduces housing demand causing home prices to be lower
than they would have been had rates not risen. This effect will be mitigated
as some borrowers switch to adjustable rate mortgages, but when short
term rates ultimately rise this will no longer be an option.
In addition, the level of interest rates greatly influences the rent
vs. buy decision. While low rates have turned many renters into buyers
in recent years, higher rates can be expected do the opposite.
Furthermore, housing demand is also determined by changes in housing
prices and expectations for future price changes, which are greatly influenced
by interest rates. Since many homebuyers are using existing home equity
for down payments, rising home prices tend to increase demand for housing.
In addition, if a buyer expects the price of the house to rise, he will
be willing to devote a larger percentage of his disposable income toward
paying for that house. For example, a buyer of a $500,000 dollar home
who expects a 10% per year rate of appreciation, expects to be able to
extract $50,000 per year though cash-out re-fi’s or lines of credit.
If that individual did not expect that level of appreciation, he might
not have been willing to pay so high a price initially.
Lastly, housing demand is determined by credit availability. The looser
the lending standards, the greater the number of buyers approved for
loans. During a falling rate environment with home price appreciation,
standards tend to be lower; conversely, a rising rate environment will
see lending standards tighten. In addition, the demand for mortgage-backed
securities in the secondary market is likely to be stronger in a falling
rate environment than in a rising rate environment, which will also contribute
to tightening lending standards.
On the supply side, as lower rates reduce the cost of home ownership,
fewer people are forced to sell their homes due to financial circumstances,
thereby reducing the supply of houses for sale. Rising home prices also
restrict supply. Typically, a person with little savings who loses his
job might be forced to sell his house, or lose it to foreclosure. But
with rising home prices and low interest rates, that unemployed individual
can borrow money against his home equity to replace his lost income.
As I have written in the past, the last thing an unemployed American
would want to do is sell his house. That’s like killing the goose that
lays the golden eggs. Besides, after taxes, many Americans today earn
more in equity extractions than they do in wages.
Also, expectations of future prices greatly affect the supply of houses
for sale. If homeowners anticipate future price appreciation, they are
less likely to sell their homes than if they expect prices to fall.
Additionally, as higher interest rates and falling housing prices lead
to a weaker economy, personal incomes will decline and unemployment will
rise. These factors will further undermine housing demand while increasing
the supply of homes for sale. The wide-spread use of adjustable rate
mortgages will only exacerbate this situation, as many borrowers will
no longer being able to afford their higher monthly payments.
In conclusion, as both the absolute level and the direction of interest
rates are the greatest factors influencing the supply of and demand for
residential real estate, they are therefore the single greatest determinant
of residential real estate prices. Rising interest rates will dampen
housing demand while simultaneously increasing housing supply. Only a
Wall Street economist could fail to draw this obvious conclusion.