How Rising Interest Rates Affect Home Prices

Economic theory implies that the two should be tightly correlated, but history suggests otherwise

600 home price reduced REUTERS Larry Downing.jpg

Mortgage interest rates will rise. We can't be sure exactly when rates will begin to climb or by how much, but we know what's coming. Since 2009, other than for a three-month period, average monthly 30-year fixed mortgage interest rates have been at or below 5%. Historically, that's completely unprecedented: average rates had never even hit 5% prior to 2009. Will home prices be affected when rates increase to more sustainable levels?

This is an important question in the context of whether or not to buy a home in the near-term. In a post last week, I explained that the current environment for home buying is relatively favorable. In particular, I said that as interest rates rise, homes will become less affordable, since mortgage payment size will increase at a given price point. Several readers objected to this line of reasoning, saying that home prices will decline farther as interest rates rise.

What Happens When Mortgage Interest Rates Rise?

Their logic is sensible enough. To understand it, let's imagine a hypothetical universe of perspective home buyers and homes. For simplicity, let's say there are three buyers and four homes for sale. Here's how the market looks (let's also assume no down payments to make things easier):

hypothetical housing market 2011-07.png

So at last week's average mortgage interest rate of 4.6%, the first column of mortgage payments applies. In that scenario, Buyer #1 buys Home A, #2 buys B, and #3 buys C. No one buys home D in this example. If interest rates rise by 2%, however, what happens?

Two possibilities exist here. The first is that all of these homes drop their prices significantly. For example, at a reduced price tag of about $525,000, buyer #1 would still be able to afford Home A at the higher interest rate. This is what the readers who objected to the reasoning in my earlier post think would happen. The family that initially owns Home A will still want to sell, so they'll have no choice but to accept a lower price because rates went up. The same goes for the other homes.

The other possibility, however, is that rising rates force buyers #1, #2, and #3 to settle for homes B, C, and D, respectively. In this case, perhaps the sellers decide they would rather not part with their homes at that deep of a loss. All three would have to take about a 20% hit. In some cases -- especially in today's housing market where equity levels are very low -- this would result in homeowners failing to break even on their home sale. Unless they have at least 20% equity, they would need to pay the bank some amount of money to sell their home or hope for a short sale.

Looking to History for Answers

So which scenario is it? To understand, we have to go beyond theory and look to what actually happens. I asked two economists who specialize in the housing market about what really occurs.

"The link between interest rates and home prices is empirically pretty weak at best," says housing economist Tom Lawler. His analysis is frequently featured on the popular Calculated Risk blog. Although some researchers have tried to link home prices to inflation-adjusted interest rates, the result have been "mixed and ambiguous," according to Lawler.

Yale economist and S&P/Case-Shiller Home Price Index godfather Robert Shiller agrees. "There is not a tight fit at all between the two: high mortgage rates do not translate automatically into low home prices," he says. In order to demonstrate his point, he provided the following data, which he compiled:

interest rates and home prices shiller.png

This shows Shiller's home price index and "long" interest rates, going back to 1890. The interest rates shown are not mortgage interest rates, because they are not available over this long period. Instead, long-term interest rates are shown, which he says tend to track mortgage interest rates. For example, the more recent data shows 10-year Treasury rates. So the rates curve doesn't show actual mortgage rates, but how they would have changed. As you can see, they didn't move in sync with home prices.

Yet Shiller also says that, in theory, rates could affect prices. He points, in particular, to the period around 1982. At that time, he notes that the Supreme Court ruled that mortgages could not be assumed by a new buyer. So with very high prevailing rates, many homeowners who had already locked in low interest rates could not afford to move. But that, in conjunction with the recession, still only pushed home prices down a little. This is the most salient story about interest rates and home prices in the last century, he says.

Why Doesn't the Relationship Hold?

Tom Lawler also provides a little theory on why interest rates don't move home prices. He says that increasing mortgage rates generally do not occur in a vacuum, but often occur due to improving economic conditions and/or rising inflation expectations. Even though an increase in interest rates should logically drive down home prices, other factors in the economy that generally accompany those rising interest rates usually prevent that from occurring.

What economic factors might have an impact? Interest rates tend to rise when an economy is flourishing. In that scenario, two things are likely to be happening simultaneously: real wages and inflation will both be rising. Going back to the example from earlier, perhaps Buyer A got a raise at work or took better job and can now afford a $4,000 payment.

Another possibility was already mentioned: prices might just be sticky. Some homeowners might simply be unable to afford to sell their home at a much lower price, if their equity level is too low. In other cases, homeowners might simply not be willing to accept a big loss to their equity. After all, rising interest rates create a domino effect: if you sell your home, then you must buy a new one at a higher interest rate than you were probably paying before. If prices don't fall broadly and in proportion to the rise in rates, then you may have to downgrade your next home.

Applying This to Our Current Housing Market

Looking at theory and past experience are both useful exercises, but how do they apply to our current situation? After all, we don't have a similar historical precedent. And trying to figure out how rising rates will affect the market in the medium-term isn't a cinch.

The big challenge is the unknown: no one has a clear understanding of precisely how the U.S. economy will look over the next decade. Many economists expect slow growth and a painfully long road to full employment. That also probably equates to low real wage growth.

In a slow recovery like this, we aren't likely to suddenly get 8% mortgage interest rates. As I explained in my post on whether or not to buy a home now, however, several factors could push up rates over the next few years, even in the context of a slow recovery -- particularly relative to their historically low levels. As of July 1st, the Federal Reserve has removed its stimulus program meant to keep longer-term interest rates low. Housing finance reform could also force the market to take on more default risk, resulting in an added risk premium to mortgage interest rates. Additionally, weak investor demand for mortgages will keep financing costs high, since the secondary market has a glut of mortgage securities to buy already, hundreds of billions of dollars of which will eventually be sold by the Federal Reserve.

So in this case, there are some factors that could push long interest rates higher, even if the recovery remains weak. In some cases, that might drive down home prices. But they're probably stickier than ever. Millions of Americans are underwater on their mortgages, which means that they will only sell their home in the near-term if they really have to, but certainly can't do so at a loss. Some Americans still have some equity left, but possibly not enough to accommodate another 10% to 20% drop in their home price if mortgage interest rates rise 1% to 2%. Remember, an average mortgage interest rate of 6.6% -- that 2% increase -- is still relatively low in a historical context.

Add all of this together and you get a very weird housing market over the medium-term. As interest rates rise, demand may weaken, but supply may as well. The home prices of many non-distressed borrowers probably can't be cut enough to entice more buyers to enter the market. The only people selling will be those that must. A day will come when the housing market returns to somewhere near normal, but that day still appears to be quite far off.

Image Credit: REUTERS/Larry Downing