Do Interest Rates Drive the Housing Market? (Maybe Not As Much As You Think…)

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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?

Photo: FreeDigitalPhotos.com

About Author

Leon Yang

Leon Yang is an active real estate investor in Las Vegas. He is a buy and hold guy who also likes to flip from time to time. His main passion is to traveling to the less traveled places and inspiring others to become financially independent through real estate.

9 Comments

  1. You said home affordability was at its best, and people weren’t buying homes. But nobody wants to buy a home and see the price drop. I think people were waiting for the bottom.

    Also you mentioned that interest rates didn’t coincide with home sales. I think there are many factors that also contribute such as the ability to obtain financing.

    I certainly know low interest rates increase demand to a degree.

  2. jeffrey gordon on

    on the margins, higher interest rates without easing payment ratios, uw standards etc. will reduce the number of people who qualify for a mortgage. In general in my mind, we are in “no man’s land” when it comes to the economy. I am advising my current clients to “lock” in the historic low rates and to closely examine the properties they are planning on holding onto–i.e. only hold the very best located properties going forward–and be very careful on acquiring any new properties–i.e. again only the best located properties.

    In addition Bawld Guy’s Sominex account strategy probably could stand an increase in liquid reserves to weather any storms upcoming.

    My son is here this weekend and we were discussing the best deal he made in the last 5 years, it was a purchase in July of 2009 in DC in what he realizes now was the bottom of the DC market. It was a gutted shell 4plex that he bought from Lehman for $52,000 in Marion Barry’s hood in Anacostia-talk about a bad location–there were 3 registered sex offenders across the street–when he decide to install a chain link fence around the back yard to keep folks from dumping debris they stole the posts out of the ground before the concrete set up after he left for the night!!!!

    He wisely decided to sell the site with some plans to another brave sole for $175,000 in summer of 2011 after putting about $20,000 into the roof etc.

    Would he take on that type of risk today after DC prices have been up about 20% per year in 2010-2013, I know I wouldn’t do it in any but the best neighborhoods,

    For me, I am keeping any eye on the Japanese Bond, stock and currency markets–they are the worlds biggest printers of money and if in fact they continue to get punished then look out below–interest rates will be the least of our worries!

    j

  3. I think you are missing a large part of the puzzle or in this case financial equation.
    In the past high interest rates kept prices in check, as did supply of homes for sale.
    Later in the totally fantasy land market created by Fannie Mae government backed financing available to anyone with a pulse, normal market economics were perverted.

    In today’s once again fantasy land market we have the lenders borrowing for near 0% but lenders are not lending, and one needs far more then a pulse to borrow.

    The shortage of housing is being artificially created in different ways in different markets, in some by Hedge Funds which have huge pools of investor money looking for a better return then Treasuries or money markets can provide.

    In my area expiring tax abatements, upside down equity positions, and just the idea that buying new beats buying old when the payment might be the same or slightly higher.

    In the end (and it will be glorious) Mr. Market is going to come his senses, when it does in my area nice rentals will be a dime a dozen, which is going to make a lot of owners very sad as they will not be able to sell in a high interest rate economy without taking a bath, or get a rent even close to break even.

    Low income for all of its issues will always be the same as, no one with a $500k condo is going to rent to a low or no credit score individual who hides behind the couch when you knock on the door looking for rent.

  4. Jeff Brown

    This might be a meaningless observation, or a solid illustration, using documented history. From the day I was first licensed, 10/69, and for 32 consecutive years without even a lone exception, I NEVER saw a conforming home rate for 80% loans that began with a number less than 7.

    The last half of both the 70s and the 80s were boom years by any objective observer. Yet no rates under 7%, and for a huge number of years the rates were 8-9.75%.

  5. I am not sure if you realize it but you made a fantastic correlation that would help folks understand how our nations finances on a whole operate as well. Monetary polocy is controlled by the Federal Reserve and as you pointed out, that is only one side of the equation. The other side is fiscal policy which is controlled by congress. When both fiscal and monetary policy are operated in unison then effective economic management can take place.

    On the real estate front I do believe that a modest increase in interest rates will only help to bolster the home prices in many areas across the nation. I do not see rates pushing to drama tically reduce buying power in the neae term and as the economy continues to improve ever so slowly it should be a fun ride. Investors must be aware of changes that are taking place and utilize these changes to their advantage not attempt to fight it because they will lose. Great article.

  6. Hi Leon,
    A very well-written article I must say. I completely agree when you say it is the availability of credit that ultimately drives the real estate market. I found some points really interesting here. Looking forward to reading more of your posts.

  7. Although I qualify for a 100K house, I wish to stay below 70K. Reason being property taxes raising every year, there needs to be a cushion to prepare for tax increases. Plus, I have a sense for quanity and value. When I see a 4 bedroom, 2 bath, 2 car garage with the same square footage as a home down the street selling for 30K less, it is pretty obvious which one I will make the offer on, especially if it only needs cosmetic work. Not only is there a cushion for taxes, but also cushion if the market plummets.

    It really ticks me off to see homeowners with homes way over priced for an average house and neighborhood.

  8. Hey Leon, nice article. I finally heard your interview on the BP podcast and it was great! You’re a sharp guy, with a lot of really good insights to share. I appreciated hearing about your approach to real estate!

  9. Kenneth Estes

    Couldn’t agree more. The period 2002 onwards isn’t a great place to start as we now know most pricing was driven by speculatively fervor. However, if you take that analysis back to the 70’s you’ll still see a very low correlation between interest rates and home prices.

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