High inflation has caused interest rates to rise quicker than we’ve seen in the United States in more than 40 years. Why? As previously discussed, inflation is a dynamic and impactful symptom of an overheated economy. As everyone tries to keep up with inflation, it tends to become self-sustaining until, like a fire, it is smothered and stopped. It goes without saying that inflation can directly impact the housing market.
Because most people finance the bulk of the cost of buying a home with a mortgage, the amount that a homebuyer can afford is highly sensitive to changes in interest rates. Unlike car loans, which have a comparatively small outstanding loan balance that declines quickly over only several years, home mortgages are much larger and are typically repaid over 30 years. The outstanding balance of a home mortgage declines quite slowly, which explains why interest makes up such a large part of a monthly payment, especially at the beginning of a mortgage.
For the last 40 years, interest rates generally declined gradually, resulting in higher home values and lower monthly payments. Today, unfortunately, we are seeing the opposite take place, primarily because of inflation. Interest rates are rising rapidly and borrowing is becoming more costly. Everyone, of course, is looking for a cure – or at least relief – from this dilemma.
Housing market conditions are turning
What are we seeing right now, given an environment where homes are less affordable because interest rates are rising so quickly? Yes, we do see some home prices are starting to decline, but only recently have they begun to really drop. The price declines we’ve seen so far do not come close to making up for the decrease in affordability resulting from rising interest rates. How, exactly, do we know that recent price declines do not come close to resolving the affordability disparity that rising rates have caused? Consider this:
According to Freddie Mac, which bundles and sells mortgages to investors in the form of bonds, the average rate on a 30-year mortgage at the end of 2021 was 3.11 percent. If you have a mortgage balance of $1 million, the monthly payment would be $4,275. As of Oct. 20, 2022 – less than a year later – Freddie Mac reported that the average rate on a 30-year mortgage has risen to 6.94 percent. The same person trying to finance $1 million of their house would now have a monthly payment of $6,612. In other words, the monthly payment would have increased by 55 percent from the end of last year. That’s significant. Put differently, for someone to have a monthly payment of $4,275 with the current interest rate of 6.94 percent, they would be financing $718,700. Either way, they would now be looking at a much less expensive property, or the original property would need to decline in price by roughly 28 percent for them to afford the same house as before.
As a result of these rapid lending rate increases, some housing transactions have started to fall through because the buyer was not able to lock in their preferred mortgage rate before it increased, thus making their previous offer unaffordable. In a worst-case scenario, a buyer might even be at risk of losing their initial deposit (typically 5 percent of the purchase price, or $50,000 for a $1 million home) in the event that a large interest rate increase was to occur after they had signed and committed to purchasing the property, but before their mortgage rate had been locked into place. This can be especially problematic for cases where there is an extended time period until the transaction closes. Fortunately, there are strategies to mitigate this risk which we have helped clients implement in order to prevent a home purchase from suddenly going sour.
What are the current symptoms of changes in the housing market?
Once interest rates began to increase, one of the first signs that market conditions were changing with them was that the frenzied bidding wars started to slow down, or even be absent altogether. Suddenly, gone were the days when sellers could move a house in three days no matter the condition and with no questions asked. Here is a personal example of how the housing market has changed.
During my own recent search to buy a home – from early 2021 to early 2022 when rates were low and it was a white-hot seller’s market – I (sarcastically) joked that one literally could sell a house with no front door in such a market. That may have been an exaggeration, but the number of homes listed with obvious problems, combined with the willingness of many potential buyers to waive an inspection, led me to legitimately question whether these uber-favorable market conditions were inspiring sellers who knew they had “difficult to sell” properties to rush for the exit while conditions were so strongly in their favor.
In such conditions, many buyers (including myself) felt they had no choice other than to hope for the best and knowingly take unacceptable risks. Having seen homebuying horror stories play out in real life, our search took much longer than planned as we frequently sidelined ourselves when met with questionable choices (we bid on only three houses over fifteen months). It now looks like those days are (thankfully) behind us.
Affordability will still be stunted for some time
One dynamic that people are now acutely aware of is that interest rates can move rapidly in the housing market. This is because short-term interest rates (i.e., the Federal Funds rate, or the overnight rate) are controlled at the discretion of the FED and recent increases have been by amounts that are quite large by historical standards. For reference, the last time the FED increased rates by 0.75% (in a single adjustment) was 28 years ago – there have been four such increases this year, so far. To put it plainly, these rates can (and have) moved quickly.
Notably, as rates continue to rise and potential monthly payments creep ever-higher for homebuyers, it’s unlikely that sellers will quickly react and “help” buyers by lowering the selling price of their home. Instead, the more likely outcome is that sellers will try to hold on in hopes that they may still receive the high asking price they may have set. In the short term, this means homes will be sitting on the market for longer periods of time given the great divide between a seller’s asking price – which may have been set based on transactions that occurred before interest rates rose – and what homebuyers can currently afford under the new, increased rates.
With housing prices exceptionally high to begin with, it’s not likely that anyone would have the capacity to afford a monthly payment 55 percent higher than what they had previously budgeted (i.e., the amount a payment would grow given the rise in rates that we have already seen occur since last year). In all likelihood, many sellers will not be willing to dramatically reduce their asking prices until it becomes obvious that market dynamics have already changed (i.e., recent comparable transactions that have closed using prices that have come down considerably).
Vacant home sales will lead the way
More likely than not, asking price reductions will begin with sales of houses that are vacant. Why? If an owner has already moved to a new property, they may now be responsible for two monthly payments (old home and new home). Carrying two mortgages can be a daunting undertaking, especially if they had to purchase the new property at a time when prices were higher than what they will be able to get for their old home. To be sure, straddling two legs of a housing change during a souring housing market is a pretty scary thought. There is one glimmer of hope though: because many sellers likely lived in their old property for a fairly long time, they should be able to sell for a profit, even in the event of a steep decline in prices.
Regardless of whether you have any housing changes planned (or recently completed), inflation is driving many people to update their financial plan. Why? Inflation has also led to large changes in operating and maintenance costs, and that affects all homeowners. In most cases, this is not about cutting spending; rather, it is about using money most effectively as changes in cash flow affect how you save, invest, or pay down debt. If you’d like to take control of your cash flows, let’s talk.
This blog was written by Jeremy Bohne, Principal & Founder of Paceline Wealth Management. Paceline is a fee-only investment advisor serving clients in the Boston area, and on a remote basis throughout the country. Paceline specializes in helping tech and biotech executives, physicians, and those seeking financial planning services.