The housing market remains on solid footing heading into 2022, but there are some threats to property prices that investors should pay attention to.
When I look at the data, the single most significant threat that I see looming for investors is rising interest rates.
Interest rates play a huge — and often underestimated — role in housing prices because they dictate the price of a mortgage, which then impacts affordability. When rates are low, as they are right now, housing becomes more affordable and prices tend to rise. When rates rise, property values can be negatively impacted due to lower affordability and less demand.
So what happens to today’s red-hot housing market when interest rates start to climb, as they almost certainly will do in the near future?
I’ll give you the answer to that question below while walking you through everything you need to know about interest rates in today’s market: where we are right now, how interest rates impact the market, and what to pay attention to in the coming years as interest rates begin to climb.
Where we are today
Over the last year, mortgage rates have either been at or near historic lows. Just look at the crazy chart below!
As is clear, the pandemic has accelerated the decline in mortgage prices — but rates have actually been on an extended downward trend since the early ’80s. The pandemic just kicked it into high gear.
Note: in this article, when I reference mortgage rates, I am referring to the average rate on a 30-year fixed-rate mortgage — as that is the mostly commonly tracked and reliable data. This may not be the exact type or mortgage you use, or the rate you get— but the lessons are applicable to nearly any type or mortgage or loan amount.
So, rates are low. But if you’ve been paying attention, you have likely noticed that they are starting to creep up, albeit very slowly. Rates recently hit 3.16% — which is still low, but up nearly 20 basis points over the last few months.
While I do believe this is the start of a long term trend of rising rates, keep that chart in mind. We’re still close to all-time lows for the time being.
I’ll touch on more about why interest rates are going to rise and what is going to happen when they do below. But first, let’s review how this era of low interest rates has helped fuel the rapid price appreciation we’ve seen over the last 18 months.
Why mortgage loan interest rates matter
To make a long story short — interest rates are what dictate the cost of a mortgage.
When interest rates are high, the borrower pays more in interest to the bank. This means that their monthly payments are higher, and borrowers have to shell out more money from their pockets to service their mortgage.
When interest rates are low, the borrower pays less in interest on the money they have borrowed. This lowers their monthly payments and allows the borrower to keep more money in their pocket.
To demonstrate just how large of an impact interest rates have on your mortgage payments, I created an Excel calculator and ran a few different scenarios through it.
The first scenario we’re going to look at is a property with a purchase of $375,000 with 20% down and a loan with a 5% interest rate.
As depicted above, this scenario produces a monthly payment of about $1,610 — with the borrower paying nearly $280,000 in interest over the life of the 30-year loan.
But what happens if we drop that interest rate to today’s rate, which averages about 3%?
With the decrease from 5% to 3%, the same property will only cost the borrower $1,264 per month — and just $155,000 in interest over the lifetime of the loan.
By decreasing the interest rate by 2% — from 5% to 3% — the borrower has reduced their monthly payment by 21%. They have also cut down on the total interest they pay the bank by 45% — which equals very significant savings.
Let’s imagine for a minute that I, Dave, was comfortable with the first scenario at 5% interest and could afford a $1,610 monthly mortgage payment. Well, when interest rates drop, I can now afford a house that is nearly $100,000 more.
Note that in the graphic above I have changed the purchase price to $475,000 — and my monthly payment of $1,602 is actually lower than it was when I was purchasing a $375,000 property at 5% interest. I would have to come up with a larger down payment, of course, but my monthly carry would actually be less.
So, if you want to find a single reason as to why home prices have skyrocketed in the last year, interest rates are it. People can afford more expensive properties because rates are so much lower.
Conversely, rising interest rates have the potential to hurt the housing market. Rising rates make mortgages more expensive, and in turn, properties are less affordable. Fewer buyers will be interested in purchasing a property that has a higher interest rate.
And, higher rates increase the debt-to-income ratio of the loan, too. Therefore, fewer buyers will qualify for mortgages based on the new higher debt-to-income ratio that comes with higher rates.
Will mortgage loan interest rates rise?
There are two primary indicators to look at regarding mortgage rates. The first is the federal funds target rate and the second is yields on the 10-year Treasury Note, which are a very common form of bond issued by the U.S. government.
Let’s first talk about the Federal Funds Rate, which currently sits near 0.
The Fed dropped interest rates at the start of the pandemic, which is a common tactic to stimulate the economy. Low interest rates make it cheaper to borrow money, which then gets more money flowing into the economy. This is also known as increasing monetary supply, and it helps grow the economy during recessions, like the brief one we saw in 2020.
In an ideal world, the Fed would probably keep interest rates low for a year or two before raising them gradually. This is what happened the last time rates were near 0, which was during the Great Recession. At that point, they raised rates gradually over a number of years so that the economy had time to adjust to higher rates while avoiding any shocks to the system.
This time around, inflation is on the rise — which is unfortunate for everyone. And now the Fed has inflation to factor in, too.
The Fed targets about 2% inflation annually, but we’re at about 6% right now. If you’re wondering why the Fed wants any inflation at all, there’s a simple reason for it: If people expect prices to stay flat or decrease in the future, they have less incentive to spend money. So, having a little bit of inflation in the mix actually stimulates economic activity.
But, let’s be honest here. No one is happy about where inflation sits today. I don’t believe it’s time to panic about inflation just yet, but the Fed will likely have to act to curb inflation more quickly than they want to — and the way they do that is to raise interest rates. That’s because rising interest rates lower the monetary supply, which helps to curb inflation.
For now, though, the Fed has signaled they won’t raise rates until late 2022. Still, it’s something to keep an eye on.
The second indicator for mortgage rates is the yield on the 10-year Treasury Note — one of the more common types of bonds issued by the federal government.
Yields have been going significantly, and when yields go up, so do the interest rates. This is a complicated topic, but the simple explanation is that treasury bonds are very safe investments. Therefore, if a bank can invest in a bond at 2% and earn an essentially guaranteed return, originating a mortgage at 3% — which is a lot riskier — looks less appealing.
As such, when bond yields rise, banks will typically raise interest rates to balance the risk vs. reward profile of originating a mortgage.
Right now, however, yields are very low. That said, they are starting to inch up for a few reasons — but I believe the main reason is the Fed’s announcement regarding how they are starting to taper asset purchases. This announcement sent yields up and is also likely the cause for the modest increase in interest rates of late.
And, with yields near historic lows, as well as the Fed reducing stimulus and the ongoing issues with inflation, it seems likely that bond yields will continue to rise — albeit relatively slowly.
So, just to recap, the two main indicators for mortgage interest rates are the Fed’s target rate and bond yields — both of which are likely to rise over the coming years. This will send up mortgage prices.
With an increase in interest rates all but guaranteed, the real question is: How quickly rates will rise and what the impact will be on the housing market?
What happens when rates rise
To understand what happens when rates rise, let’s take a look at some historical data.
Housing prices and interest rates are negatively correlated. This means that they have a relationship — but when one goes up, the other goes down, at least historically speaking.
But to be clear, this doesn’t always happen. Look at what happened between 2011 and 2017. Look at what happened in 2019. Look at what happened in the late ’70s and early ’80s, when interest rates were at all-time highs! It’s not a perfect correlation.
That imperfect correlation is precisely why we don’t really know for sure what will happen when rates start to rise. Still, we can make some informed conclusions about what investors should do in this economic climate:
- If you haven’t yet secured a refi on a property you intend to hold on to for a while, it’s time to do so right now. That’s a no-brainer.
- While the market outlook is unclear for the next five years, locking in a 30-year rate at historic lows is likely a good idea for investors who are in it for the long game. I think 2022 will be strong, but it’s too early to tell what will happen in 2023 and beyond.
- Keep an eye on how quickly rates rise to understand the potential impact on property values. If rates rise quickly, it could cause a shock to the system, and housing prices could slide backwards. But, the Fed is not likely to do that. They will likely try to raise rates as slowly as possible to allow economic expansion and wage growth to counteract the impacts of rising rates. This is what happened post-Great Recession, which was one of the strongest periods of property price growth in American history — despite rising rates. That said, if inflation stays high for too long, or even starts to accelerate, the Fed could be forced to raise interest rates faster than they want to, which could hurt housing prices.
Before wrapping up, I want to make one thing clear: When I say rising rates could hurt housing prices, I am not necessarily saying that this would be a housing crash. In my mind, a crash is a drop in asset values of 20% or more.
I think it’s very unlikely that interest rate hikes alone would cause that kind of decrease. Rather, I think rapidly rising rates could lead to a period of flat growth or modest price declines in the coming years.
That said, if rising rates were to be coupled with a sharp increase in housing supply or a big drop in demand, that could certainly cause a crash. But if you watch any of my videos, you know I think that is pretty unlikely. So, my outlook remains the same. I believe in 2022 we will see solid price appreciation because interest rates won’t rise too rapidly.
Once mortgage rates rise to about 3.75% to 4%, which I believe will be in 2023, I think values could be negatively impacted, but we’re still a ways off from that. Right now, I don’t think anyone has enough data to accurately predict what happens beyond the next 12-18 months.
The best thing to do is focus on what we do know: rates are low, demand is high, and the 10-year outlook for the housing market is extremely strong.
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.