An easy answer to this seemingly simple question is “Yes.” All things being equal rising rates mean higher monthly payments, fewer folks qualifying for home purchases, and fewer folks wanting to buy because the cost of ownership is just out of reach.
But those are temporary issues. The market will adjust, settle in to a new equilibrium, and then go on again normally at perhaps a very slightly lower price level than it would have been if interest rates didn’t rise.
An article in Marketwatch today makes an interesting point about move-up buyers, however. There are concerns about the housing sector, but not exactly what you might think.
What rates do the Feds Control?
First – just to be clear – the Feds don’t control mortgage rates, and when (not if, because I’m bold that way) they raise short-term rates on December 16th it will not necessarily affect mortgage interest rates. I’ve said this before, and I’ll write more on this in another post in the near future.
How do interest rates affect housing prices?
Most pundits believe that when mortgage rates do go up, it will impact demand for housing because higher interest rates mean higher payments, and higher payments mean lower affordability.
Many real estate economists, on the other hand, argue that a small increase in mortgage rates does not make a major difference in the monthly payment. This is objectively true. The monthly payment on a $400,000 30-year mortgage at 4.000% would be $1,909.66. At 4.250% the payment would be $1,967.76, an increase of less than $60 per month. Certainly some will be affected, but most will not.
If demand won’t change that much, then how will the bump in rates have an impact on the real estate market?
Will the shortage of listings get worse?
One of the biggest obstacles to buying a home this year has been the dearth of listings. A bump in the interest rate – even a small bump – just might exacerbate this dearth. Stay with me for a moment.
In Silicon Valley the higher-end properties have done very well in the last three years. Move-up buyers have been somewhat scarce, though, because the dearth of listings has made folks nervous about selling, since they aren’t sure if they will be able to find a home to buy. This has created a negative feedback loop, where home owners stay put rather than buy up as we would expect them to, and thus contribute to the dearth of listings.
In Silicon Valley this has been somewhat mitigated by the fact that first-time home buyers are actually buying homes over $1 million due to extremely high incomes and soaring stock prices. They have the cash for a huge down payment and the income to support the mortgage.
It’s the monthly sticker shock
But back to those move-up homeowners who aren’t moving up. They could very well impact the market. Let’s examine why this is.
We’ll assume that our intrepid move-up buyer owns his starter home worth $650,000 and owes $350,000 on it. He refinanced at rock-bottom in April of 2013 so he got a super-low interest rate of 3.500% and he paid about $500,000 for his home a few years earlier, so his property taxes are $550 per month. After sale costs and paying off his mortgage, he will net about $248,000 from the sale of his home.
He wants to move up to a nice little tract home, which in San Jose means $950,000, a reasonable upgrade of just under 50% in price point. He has enough to put 25% down on his new house to get the best possible mortgage rate, but his loan amount is now over the high-balance conforming loan limit, and rates are higher, so his new interest rate is 4.250%.
You’ll notice he has moved virtually all of his equity into the new home, so he has a little left over for moving costs and maybe some personalization of the new home, but that’s about it.
Now, note that his total monthly housing payment will increase from $2,291.35 to $4,594.66, an increase of $2,303.31, almost exactly double his old payment.
Wait, what? He didn’t double his house, why did his monthly payment double?
First, he needs to borrow a lot more money at a higher interest rate, so the mortgage payment is considerably higher.
Second, in California our assessed value can increase a maximum of only 2% per year by law under continuous ownership, but the property is reassessed when sold. The assessed value on the old home was at about $550,000, and the new assessed value will be at $950,000. The property taxes are thus quite a bit higher.
Finally, the higher the value the higher the insurance premium, all things being equal.
If our intrepid homeowner looks at this analysis, will he hesitate before pulling the trigger to sell and move up? Yes, he might.
Different market segments will react differently
The point is, moving up in California already involves some steep monthly housing cost increases. Let’s think about how rising interest rates might exacerbate the impact on housing cost and thus the real estate market.
Entry-level homes will be very slightly more expensive than they would be without an interest rate increase, so demand may slack just a little. But there are a lot of entry-level buyers out there right now, with many would-be home buyers having been kept out of the market for too long. On the other hand, move-up sellers will be even less likely to sell than before, so supply will also diminish. The net effect may be that entry-level homes may just increase in value more than the rest of the market.
Mid-level homes will be slightly more expensive to carry on a monthly basis than before, too. If move-up buyers stay out of the market as expected, demand in this range should diminish. In our area, however, strong incomes and a robust stock market will continue to drive first-time home-buyer demand, even in this price range, so prices in the mid-level will still find some support in the market.
High end homes will become a lot more expensive to own when interest rates rise. To the degree that large increases in housing costs deter some move-up buyers, demand for these homes will likely fall quite a bit, and the prices on homes over about $1 million will probably level off for a while when interest rates finally start to rise.
Don’t panic. Demand for housing in Silicon Valley is still very strong. I do not foresee a collapse of values in any scenario.
And remember, the Feds don’t control mortgage rates directly. When they act on December 16th they will raise short-term rates. To see how that might impact you, read my blog of November 30th.
What you should really be watching on December 16th
One final note: The Feds are still buying mortgage-backed securities each month, indirectly keeping mortgage rates low. While the eyes of the world on December 16th will be on announcements about short-term rates, what you really want to watch out for will be the release of the minutes about three weeks after the meeting (so, early January) and details about whether or not they intend to continue purchasing mortgage-backed securities. That could be a major market mover. (Not in a good direction.)