Authored by Michael Lebowitz via RealInvestmentAdvice.com,
There are a large number of public and private services that measure the change in home prices. The algorithms behind these services, while complex, are primarily based on recent sale prices for comparative homes and adjusted for factors like location, property characteristics and the particulars of the house. While these pricing services are considered to be well represented measures of house prices, there is another important factor that is frequently overlooked despite the large role in plays in house prices.
In August 2016, the 30-year fixed mortgage rate as reported by the Federal Reserve hit an all-time low of 3.44%. Since then it has risen to its current level of 4.50%. While a 1% increase may appear small, especially at this low level of rates, the rise has begun to adversely affect housing and mortgage activity. After rising 33% and 22% in 2015 and 2016 respectively, total mortgage originations were down -16% in 2017. Further increases in rates will likely begin to weigh on house prices and the broader economy. This article will help quantify the benefit that lower rates played in making houses more affordable over the past few decades. By doing this, we can appreciate how further increases in mortgage rates might adversely affect house prices.
Lower Rates
In 1981 mortgage rates peaked at 18.50%. Since that time they have declined steadily and now stands at a relatively paltry 4.50%. Over this 37-year period, individuals’ payments on mortgage loans also declined allowing buyers to get more for their money. Continually declining rates also allowed them to further reduce their payments through refinancing. Consider that in 1990 a $500,000 house, bought with a 10%, 30-year fixed rate mortgage, which was the going rate, would have required a monthly principal and interest payment of $4,388. Today a loan for the same amount at the 4.50% current rate is almost half the payment at $2,533.
The sensitivity of mortgage payments to changes in mortgage rates is about 9%, meaning that each 1% increase or decrease in the mortgage rate results in a payment increase or decrease of 9%. From a home buyer’s perspective, this means that each 1% change in rates makes the house more or less affordable by about 9%.
Given this understanding of the math and the prior history of rate declines, we can calculate how lower rates helped make housing more affordable. To do this, we start in the year 1990 with a $500,000 home price and adjust it annually based on changes in the popular Case-Shiller House Price Index. This calculation approximates the 28-year price appreciation of the house. Second, we further adjust it to the change in interest rates. To accomplish this, we calculated how much more or less home one could buy based on the change in interest rates. The difference between the two, as shown below, provides a value on how...