The following is an addendum to "Record Low Mortgage Rates Make Now a Terrible Time to Buy a House" and the discourse which followed.  The article is written so that its content may stand alone, but the earlier analysis may be viewed here. 

Introduction

A reader proposed the interesting notion that when mortgage rates begin to rise, demand for houses, and potentially home prices, would also increase.  The thinking goes that sidelined buyers will enter the market out of concern that steadily rising interest rates would make homeownership less unaffordable.  This is the assertion that the National Association of Realtors will make.

While interesting to consider and a potentially effective marketing tactic, the conditions which orchestrated The Housing Bubble dictate that neither artificially low, nor rising , mortgage rates will solve the present crisis, increase demand or prop up housing prices at unsustainable valuations.

Chasing Interest Rates

In fairness, there are plenty of circumstances where rising mortgage rates might cause an individual to purchase a home. 

1. If rising rates were expected to increase the net cost of homeownership, it would be reasonable to buy now versus later and lock in today's lower expense

2. There will always be buyers susceptible to marketing claims.  NAR's contention that one must buy now, else pay higher rates in the future, will catalyze some amount of demand (I note that NAR always recommends buying regardless of circumstances)

3. Some people place a premium on the value of homeownership distinctive from financial encumbrances.  If owning a home for social, cultural or other reasons is the goal, and higher mortgage rates represent a perceived impediment to realizing this objective, it would make sense to buy in an environment where rates are rising

Peculiarities of the Housing Bubble

A curious aspect of the Housing Bubble (which explains why it came into being and perpetuated) was that for a decade, while housing prices were rising, the cost of homeownership was actually falling.  As a result, many buyers were functionally insensitive to price.  (A more detailed analysis may be reviewed at "Why This is The Affordable Mortgage Depression")

A house's price is only one component of the cost of homeownership which also includes:

• Required down payment
• Marginal and effective interest rates on a mortgage
• Access to credit (Subprime, Alt-A, ARMs, Option-Arms, HELOCs, refinancing, Interest-Only)
• The terms of principal repayment

The interplay between the requirements necessary to access homeownership (credit, capital and cash flow) directly determine housing prices.

Additionally there are qualitative metrics which influence price including:

• Perception of risk (housing prices had not fallen in 70 years)
• Expectations of future price performance (housing prices had been rising steadily and accelerating since 1997)
• Cultural, social and other premiums attached to homeownership

During the Housing Bubble the cost of accessing homeownership fell dramatically as the requirements that a buyer contribute a material down payment and service a fixed mortgage rate evaporated.  It became cheaper to "buy" a home with a no-down payment, ARM than it was to obtain an apartment which required a security deposit and fixed rental payment. 

The economic impact of this phenomenon persists today as many ARM holders are hopelessly underwater and heading for foreclosure, but continue to live in their houses until the mortgage resets because the introductory rate is still cheaper than renting an equivalent home.

A New Reality

The housing market today does not resemble that which existed for 70 years following the Great Depression or during the Housing Bubble. 

• Housing prices are falling and likely to continue to depreciate
• Affordable Mortgages which propelled prices to unsustainable heights no longer exist
• Robust economic activity has collapsed into record unemployment
• Low inventories and rampant demand has turned into excess inventory and record distressed transactions

1.  Mortgage Rates Do Not Matter When Housing Prices Are Declining

When asset prices are falling and potential buyers expect continued depreciation, rationale people stay out of the market regardless of the cost of borrowing.  While the mortgage payment on a house today may be lower (or higher) than it was last week, why would a prospective buyer purchase a house that is declining in value?  Waiting a year (or three) allows a buyer to purchase the asset more cheaply.  Buying a house today only exposes the new owner to leveraged equity losses.  This is the danger of deflation relative to highly levered assets.

2.  Marginal Interest Rates Today Are Much Higher Than During the Housing Boom

The Bubble was fueled partly by extraordinarily low interest rates.  While 30 year mortgage rates were widely reported during the boom, they were also largely irrelevant.  Buyers and investors at the margin relied on ARMs and Option ARMs which provided the ability to service mortgages for as little as 1% per year.  It was low effective interest rates that supported unsustainably valued housing prices.  When these economic time bombs were eliminated, marginal interest rates rose dramatically.

Despite the headlines, mortgage rates have not dropped to 4.9% they have increased from the 1% to 2% range.  Current housing valuations remain unsupportable at the current interest rate level and prices will continue to fall.  Should the 30 year fixed rate rise, the much needed market correction would only accelerate.

3.  Non-Interest Rate Market Forces Will Continue to Determine Home Prices

Interest rates are an important force in the determination of housing values, but they are presently a minor one.  Housing prices will continue to be dominated by:

• The supply of unoccupied houses
• Housing inventories for sale
• Demand for home purchases
• Credit availability and terms
• Unemployment levels and trends
• Consumer confidence
• Perceived risk
• Expectations of future price changes
• Changing social and cultural values associated with homeownership
• Foreclosure volumes and trends

Almost every fundamental determinant for the market value of houses today is less favorable than that which existed in the late 1990s.  Prices will continue to fall for the foreseeable future irrespective of mortgage rates. 

When Mortgage Rates Rise

Higher mortgage rates will increase the net cost of homeownership.  Unlike during the past, rising rates would not be offset by other factors which reduce expense, or contribute to a positive expected return.  As the price of homeownership increases, and the expected return from homeownership falls, economics dictates that both demand and price will decline further. 

There are exceptions to this rule, as detailed above, but these will be insufficient to overcome market realities which are determining price including:

• An overvalued, overleveraged housing stock
• An altered financing environment incapable of supporting current valuations
• An economic backdrop which cannot support existing home prices
• Excess supply, insufficient demand and rising backlog of distressed transactions
• The changing perception of housing risk

An Historical Analysis of the Relationship Between Mortgage Rates and Demand for Housing

Graphical analysis and commentary to be included as a separate article.