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HIGHER INTEREST RATES AFFECT ON THE HOUSING MARKET
The nation’s housing markets achieved a new record high pace of sales last month, but the heightened activity may be more a sign of slowing to come than a signal of a continued bull market. The trigger in both instances is higher mortgage interest rates, which push waffling home buyers off the fence into home purchase transactions, then force marginal or noncommittal buyers out of the market altogether.

Experts agree the days of 5 percent mortgages are over and higher monthly payments inevitably will force the housing market to slow down. Buyers will find homes to be less affordable than they recently were and sellers won’t realize as much house value appreciation as they’ve netted in recent years.

“Long-term rising rates definitely impact the market as far as slowing (home) sales,” said Leslie Appleton-Young, chief economist of the California Association of Realtors. That’s because higher interest rates “deteriorate” affordability, she said. Financing a home purchase becomes more expensive and fewer buyers can qualify to purchase a median-priced home as interest rates rise. Housing affordability drops 1-2 percentage points with every 50-basis-point increase in long-term mortgage rates, according to C.A.R. Research Analyst Sara Chaloen. That means the affordability index in California would fall three points if the average interest rate on 30-year fixed-rate mortgages increased to 6.5 percent. And that would prevent 360,000 households from buying a median-priced home in the state.

Rock-bottom mortgage rates earlier this year helped maintain affordability in California, despite double-digit home price appreciation. “If the mortgage rate had not dropped by more than one percentage point from a year ago, housing affordability would have been hit hard in recent months because of the constant rise in the median home price,” Chaloen wrote.

The national pace of home sales will slow down and pressure on home prices will soften later this year if the gradual rise in long-term mortgage rates continues as economists expect. Higher interest rates hurt home price growth because higher borrowing costs push some buyers out of the market and inhibit others from entering bidding wars for for-sale properties, economists suggest.

The national pace of home price growth was 6.48 percent in the first quarter of this year, according to the Office of Federal Housing Enterprise Oversight, which tracks the statistic. National Association of Realtors Senior Economist Lawrence Yun said that figure could cool to a rate of 5.5 percent through the end of this year and 4 percent in 2004 due to increases in long-term interest rates. The average interest rate on a 30-year fixed-rate mortgage climbed a full percentage point since June to 6.28 percent this week, according to mortgage buyer Freddie Mac. The jump prompted a higher percentage of homebuyers to opt for adjustable-rate mortgages, which open with a lower initial interest rate that can fluctuate later. The fact that some homebuyers no longer can afford to buy the house they want to purchase could force sellers to lower their asking prices to accommodate softening demand.

The housing market won’t crash as a result of rising interest rates—at least not anytime before the next Presidential election in November 2004, according to Christopher Cagan, director of analytical research for First American Real Estate Solutions. Cagan believes the real estate market will remain strong through 2004 because the Federal Reserve and its chairman, Alan Greenspan, want to stimulate the economy and President Bush wants to win a second presidential election. Bush risks losing in 2004 if the economy falls back into recession despite his declared victory in Iraq because voters may not look back that far in the President’s term. “It’s known that the American public doesn’t have a long memory,” Cagan said. He pointed out that Bush and the Fed will do whatever is necessary to avoid an economic recession like the one that caused George Bush Sr. to lose the 1992 election even if anti-recession actions spur a rise in inflation. But Cagan believes the housing market would perform well even if the Fed’s actions spurred higher inflation.

The graph below depicts the effects of higher interest rates on purchasing power. Assuming an individual has $100,000 down and can afford a monthly payment of $2,147.29. The graph shows how much home this individual can afford as the interest rates rise. As you can see each 1% rise in interest rates creates an affordability reduction of approximately 7%.