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Expect Housing Sale Price Drops As Rates Rise

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Does it matter if you have a $300k mortgage at 5.5% or a $270k mortgage at 6.5%? In the the last few years we’ve seen housing prices skyrocket while mortgage interest rates have remained extremely low. Now that rates are increasing, we’re probably going to see housing prices slipping a little as to keep the relative monthly cost at about the same levels (plus a bit of appreciation) and thus the total payout at the same levels (if you keep the home until you fully pay off the mortgage). Recall that the payment has a principal and an interest component so with interest rates rising, a greater portion of the total payout will shift from the interest column to the principal column. One would anticipate housing prices slip a little, or not rise as quickly, as interest rates rise because buyers don’t have any more money when the rates rise and thus the total monthly price must remain the same.

Assuming a 30 year fixed interest rate mortgage loan:

Mortgage Amount Interest Rate Monthly Payment Total Interest Total Payments
$300,000 5.50% $1,703.37 $313,210.13 $613,210.43
$270,000 6.50% $1,706.58 $344,372.91 $614,372.91
$244,000 7.50% $1,706.08 $370,193.75 $614,193.75
$194,500 10.0% $1,706.88 $419,969.90 $614,469.90


Now one would argue that part of that interest will be returned to you each year because of the mortgage interest deduction so to make that comparison (and to make it simplistically) we’ll simply take the difference in interest payments, divide by 4 (assuming a 25% marginal tax rate), and find that the difference is about $7800 over 30 years between the 6.5% and the 5.5% interest rate rows. Granted, the rebate should be heavily skewed towards the front of the loan but it’s a mere $7800 on a six figure loan (2.8%). When you compare the difference between the 10% and 5.5% loan, it’s a more significant $26,689.94 (13.7%).

However, one thing this does illustrate is that the price of the house should fall as interest rates rise because the monthly payment should remain the same for one house. As rates approach 6.5%, one would anticipate that a $300,000 house would sell for only $270,000 and that you shouldn’t worry when it does. This doesn’t bode well for people who are flipping homes and could be why existing home sales have slowed down?

Caveats: This simple math ignores or simplifies a lot of things like how the mortgage is amortized, the type of mortgage (30-year fixed), transaction costs, inflation, etc. I think it’s conceptually right though and if I’m wrong, I’d really like to hear about it.

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5 Responses to “Expect Housing Sale Price Drops As Rates Rise”

  1. Miller says:

    This is a good little comparison. I have often taken the same view point over the last few months . I’d like to add a reason of justification too. Simply stated, people can only afford what they can afford (duh). But, this does actually mean something. The median income person out there can’t pay/afford more in his monthly budget simply because the rates went up. Either the price has to drop, or that person buys “less house.” However, if that person is forced to buy “less house” then you should see some supply/demand relationship develop. Now the median person isn’t shopping for that 300k house (for example). Hence, demand for 300k goes down, and the price corrects itself a little bit — resulting in the same effect. Anyway, that’s my thinking here.

    Another interesting point (and possible counter to my above argument) is: then why were prices increasing over the last two years or so if rates had stayed about the same (rock bottom). Well, two fold. One, there is always going to be some lag in the system (be it real estate or whatever). It takes time for people to realize that they should take advantage of the market, but none the less the demand is increasing over time, and hence the price until… The price becomes too much, and again there is a lag before people realize these deals aren’t so great anymore. Anyway, reason two (and I read this somewhere… probably cnn money), those “exotic loans” have become much more popular. Loaners have become more willing to give them out. By exotic loans, I’m talking about the interest only, 0% down, etc. Anyway, with interest only (for example), for the same monthly cost, I can buy a more expensive house. Hence, over the last couple years as those types of loans have become more popular, median income dude can afford a more expensive (in terms of price) house. One would have to think that the exotic loans only became popular because the housing market blew up so much and loans became very confident in their loanees ability to pay because housing was sky rocketing (so this “exotic loan” effect followed the first I mentioned — lag on the good market). But it makes you think… easy come, easy go… look out!!! =)

  2. Avery says:

    One key factor not mentioned above is that there’s been a lot of buying of houses solely as investments rather than as a place for the purchaser to live in. Once the real-estate market levels out (as everyone hopes) or falls (as everyone fears), investors will try to unload their realestate investments and reallocate them into other sectors (e.g. stocks, bonds, etc) that can return better yeilds. Doing so can cause the market to spiral down as it in time becomes a rush to sell properties.
    Many people bought into this market in the past few years based on hysteria and the incorrect belief that housing prices can only go up. In actuality, there have been regional depressions in prices throughout the century and, despite the boom of the past 10 years, realestate is still viewed as a very risky investment compared to even aggressive domestic stocks.
    A lot of how this plays out depends on how high interest rates will rise. The fed hinted they’ll start to slow down the hikes, but economists fear that the fed will overshoot where we need to be. Since yes, there will be a long lag to see consequences, we may not get a clear idea of whether the market will tank until a year from now.
    Personally, with all that said, instead of buying a house with my money, I’ve invested it elsewhere– mostly in global stocks– and expect to come out ahead in a couple of years.

  3. Avery says:

    One other note to mention is the high amount of people taking out interest-only mortgages, banking that interest rates will always stay low and housing prices can only increase. Interest-only mortgages accounted for nearly 60% of all mortgages this past year, and you can bet that there will be a lot of people in for a rude-awakening as rates keep inching higher and investors unload their properties in search for better investment yields.

  4. Dan Melson says:

    You might want to stop by and check out my article named Cold Hard Numbers at http://www.searchlightcrusade.net/posts/1124114437.shtml

    I have done several more on the issue, such as “Housing Bubble” at http://www.searchlightcrusade.net/posts/1128434427.shtml

    Most often, what happens, as is happening now, is that as the rates begin to rise, people move first into alternative loan types. In some markets, this is the third year for those. Only then, when there are no more buyers, do prices fall. This is starting to happen in San Diego, where I am, and DC, both often housing bellwethers.

    Often, once housing begins to slump, it significantly overshoots – downwards – the “payment breakeven” you speak of, for reasons much like what happened when the tech bubble popped – people got scared, and panicked. Your math looks about right without hauling out the calculator. But math is the least of the factors that goes into this.

  5. Rick says:

    One thing to remember, people, is that Housing prices are sticky upward, meaning that if someone offers more money, a bunch of people will sell, making it look like a bubble, but when prices are not jumping, a lot of people say “Oh well, we can live here a bit longer”. This means that PRICES stay the same, but volume dries up. I don’t worry about my house losing value, I am worried about it being on the market for 180 days…

    Rick


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