At first, it sounds pretty simple right?
It makes logical sense that as interest rate goes lower, the housing prices will go higher. But like many things in life, this concept is not really cut and dry. So let’s dig a little deeper and see what we can find.
What drives housing prices? Theoretically it is supply and demand that drives a market price on a house. Focusing on demand for a minute, the price of a house is really at the price of what the next buyer is willing to pay. While it is true certain markets investors are gobbling up homes with straight cash purchase, the majority of the homes across America are paid by Americans via a mortgage. Most buyers will be purchasing a house at the payments and price that he or she could afford. A variable essential to that equation is the interest rate.
So, would it be safe to say that as interest rates go lower, the buyer’s payment would be lower, and thus translates into a buyer being able to afford a higher purchase price?
Yes it would be safe to say that. However, just because the buyer is ABLE to pay a higher purchase price, does that mean the buyer is WILLING to pay?
When I looked back at the Federal Reserve Funds Rate chart from 2002 to today, I noticed that interest rates moved along with housing prices starting in the middle of 2004. In other words, as interest rates went up, which according to theory, should have raised buying costs and dampening demand, home prices also shot up. As we move from 2007 to 2009, the subsequent drop in interest rates also corresponded with a tremendous drop in home prices as well.
So What is That Telling Us?
Well, for one thing, I would not be arguing that interest rates and home prices do the opposite of what theory says. However, it is clear that interest rates do not play a significant role in affecting the market (I suppose you could have argued that the effects of home prices could have been even more skewed had it not been the changes in the interest rate, but I don’t really buy it).
Even as the Fed dropped the Funds Rate to 0%, for the longest time there were no buyers in the market. Home affordability at some point was at the lowest it had ever been. But you do not see buyers WILLING to buy homes. More interestingly, there was a time when buyers weren’t ABLE to buy homes as well – due to the contraction of credit by banks (sorry, we can’t lend to you anymore because we are starting to have 3897834 more guidelines that you do not meet).
With banks as gatekeepers, how would there be demand at all even if the interest rate is at 0% if you could not get a loan from the bank?
I have talked about my theories on what drives real estate prices. In my opinion, interest rates rather play a minor role in the scheme of this whole thing (obviously, rate changes have to be within reason. If interest rate suddenly shoots up 20% we are talking a whole new ballgame). I think the availability of credit is ultimately what is going to drive the real estate market. We may see a real boom again if banks start to flood the market with credit again. I would pay more attention to that than to interest rates.
On the other hand, newspapers wrote the recent rise in interest rates had sparked even more demand. Wait, doesn’t that also go against the common conception that interest rates and housing prices move in opposite direction?