With mortgage rates hovering near 7%, it’s worth looking at their impact on housing affordability. Higher financing costs reduce affordability and create downward pressure on home prices. The impact of higher rates on affordability has been obvious, but the impact on housing prices is more complicated.
Mortgage rates are up from under 3% at the end of 2020 to about 6.8% today. Increasing mortgage rates from 3% to 7% raises monthly payments on a $400,000 30-year mortgage from $2,338 to $2,973 or 27.2%. This analysis excludes taxes and insurance.
However, housing prices continued to sharply appreciate during 2021 and 2022, before levelling off more recently. Both the Case-Shiller and Federal Housing Finance Agency housing price indices are about 28% above December 2020 levels and remain near all-time highs.
Lack of affordability can place downward pressure on housing prices. One way of looking at the interaction between mortgage rates and home prices is to translate monthly mortgage payments to implied home prices. Let’s take a $400,000 30-year mortgage with a 3% interest rate. The monthly mortgage payment would be $2,338. How large a mortgage could you get for that $2,338 monthly payment if rates are 4%, 5%, 6%, or 7%? As shown below, raising the rate from 3% to 6.8% means that the $2,338 monthly pay would now only support a mortgage of $309,000, a decline of 22.8%.
Why the apparent disconnect between home prices and affordability? Asset prices aren’t entirely guided by fundamentals. Affordability doesn’t solely determine housing prices any more than price-earnings ratios determine stock prices. Relationships are a lot more complicated, though an imbalance now can lead to problems later. While higher financing costs affect national affordability levels, there are also enormous regional variations in affordability. As of April 2023, the affordability index ranged from 116.3 (most affordable) for Scranton/Wilkes-Barre, PA to 38.2 (least affordable) for Los Angeles/Long Beach.
Measurements of home price appreciation have their limitations. Houses don’t turn over every month or every year and the underlying product varies by age, condition, design, and a host of other factors. There is also the potential for selection bias when it comes to either buying or selling a home. A house is the most significant asset for many people, which can affect reactions to down markets. Some may decide to remain in their homes or rent them out rather than sell at a loss.
One way to prop up housing markets has been through looser underwriting standards and “innovative” but risky products like interest-only mortgages. That was the approach prior to the Global Financial Crisis and did not end well. That is not yet happening in a big way. The Share of non-qualified mortgages has more than doubled since 2020 but remains a small share of the market.
The impact of high mortgage rates will also depend on the size of the downpayment. The average downpayment nationwide is 13% but can be as low as 3.5% for FHA loans and zero for VA loans. The typical downpayment for first time homebuyers is only 7%. Trends in median home prices by type of financing also suggest this may be the case. As shown in the table below, prices of homes financed by conventional mortgages have appreciated more and are closer to their peak prices than those financed by VA and FHA mortgages.
These trends are only roughly indicative. Tracking the median home price is different from tracking prices for individual homes. In addition, cash purchases have appreciated less (+18.15 since December 2020) and are farther from their peak (-8.3%) than houses financed with conventional mortgages. However, when we look at average home prices, cash deals are up more than conventional mortgage deals (38% vs. 33.9%).
Housing prices reflect not just current income levels and current housing costs, but also expectations. A key feature of residential mortgages in the United States is that borrowers usually can prepay without penalty. Prospective buyers might be willing to accept higher monthly payments today if they figure they can later refinance in a more favorable rate environment. The trouble is that low downpayment mortgages provide much less flexibility in this regard. It may take only a modest decline in price for the home value to fall below the mortgage balance. Few if any lenders will be willing to finance if the mortgage is underwater. You are essentially stuck at the high rate, at least until the market recovers.