About the Author: Claire Losey is an assistant research economist at the Texas Real Estate Research Center at Texas A&M University.
Sorry, potential buyers, but your luck has just taken a turn for the worse. If you thought it would be difficult to buy a home in a market with strong and sustained demand for homeownership and low inventory (oh, and record house price appreciation), add to that the rise in mortgage interest rates. In a market where affordability is already shrinking, the competition to buy a home has become even tougher.
It’s no secret that inflation is currently a major headwind for households, businesses and the economy in general. The Consumer Price Index, which represents the average price of a basket of consumer goods and services, increased by nearly 8% from February 2021 to February 2022. (Since January 1948, the one-year change to the other of the CPI has averaged 3.48%, including double-digit annual growth in the 1970s and 1980s.) As the growth rate of the CPI increases, the power of d consumer purchase decreases. Simply put, your dollar doesn’t stretch that far, so you have to spend more money to buy the same goods and services, leaving you with less residual income for savings or discretionary items.
To fight inflation, the Federal Open Market Committee decided on Wednesday to raise the federal funds rate, the interest rate at which depository institutions and financial institutions (i.e. banks) charge lend additional reserves overnight. It was the first time Fed policymakers raised the rate since 2018. After hovering between 0% and 0.25%, the FOMC opted to initiate a quarter-percentage-point hike in the U.S. rate. federal funds, which now fluctuates between 0.25% and 0.5%. . Experts predict six more rate hikes this year alone (each by a quarter of a percentage point), which would leave the fed funds rate between 1.75% and 2% by the end of 2022.
Why is the increase in the federal funds rate important for potential home buyers? In short, the mortgage interest rate loosely tracks the federal funds rate. (“Vaguely” because the relationship is intermediate by the 10-year Treasury yield.) As the rate rises, the cost of borrowing capital, or interest rates for credit card loans, loans autos, student loans and, yes, mortgages, will also increase. This reduces household demand for big-ticket items typically financed with debt, such as cars, homes, and college education. And most homebuyers—87%according to the National Association of Realtors – use mortgage financing to buy a home.
Even before the announced rate hike, mortgage interest rates were rising, largely in response to the rise in the 10-yield Treasury yield. After reaching a record low of 2.65% in January 2021, the average rate for a 30-year fixed-rate mortgage rose above 3.92% in mid-February before falling back to 3.85% in early March. (The average rate has since risen at 4.16%). At the start of the year, many forecasts indicated that mortgage interest rates would hover around 4% by the end of 2022, but the forecast will likely be adjusted upwards in response to the Fed’s signal of seven hikes rate hikes in 2022. (It was more common to expect four or five rate hikes earlier in the year.)
Mortgage interest rates play a critical role in a household’s ability to purchase a home. As the rate increases, the total monthly mortgage payment also increases. This payment is known as “PITI”, for principal, interest, property taxes and insurance. Assume the typical buyer puts down 80% on a 30-year fixed rate mortgage and pays property tax and insurance equal to 4% of the price of the home. For a buyer with a conventional mortgage, the total monthly mortgage payment for the median priced home in 2021 ($353,400 according to National Association of Realtors) is $2,317 at 2.65%, $2,387 at 3.11% and $2,503 at 3.85%. In other words, increasing the mortgage interest rate by 1.2 percentage points from 2.65% to 3.85% increases the total monthly mortgage payment for the home at the median price by almost $200, that’s more than $2,200 per year. The effect of a rate increase on the total monthly mortgage payment is smaller for lower-priced homes and larger for higher-priced homes.
As the total monthly mortgage payment increases, the income required to qualify for a mortgage also increases. With a mortgage interest rate of 2.65%, a homebuyer looking for a conventional loan would need nearly $93,000 in qualifying income for the home at the median price in 2021. However, this income rises to almost $95,500 with a rate of 3.11%, and just over $100,000 with a rate of 3.85%. The 1.2 percentage point increase in the rate from 2.65% to 3.85% represents an increase of nearly $7,500 in the income required to qualify for a mortgage. As with the total monthly mortgage payment, the effect of a rate increase on the qualifying income requirement is smaller for lower-priced homes and larger for higher-priced homes.
As the mortgage interest rate increases, the maximum affordable house price for a household decreases. With a mortgage interest rate of 2.65%, a typical buyer with a conventional mortgage could purchase a home at 3.81 times household income. For example, a buyer with a household income of $100,000 could afford a maximum house price of $381,000 with a rate of 2.65%. A household could afford a maximum house price of $353,000 with a rate of 3.85%, down from nearly $30,000 or 7.3%.
In an era of record house price appreciation, the decline in purchasing power will prove more acute for all households, but particularly for the most modest and first-time buyers, who are already facing income constraints. , wealth or credit (and often all of the above). For fringe households or potential buyers who barely meet the criteria to qualify for a mortgage, an increase in mortgage interest rates could push them into “unaffordable” territory. In other words, it could prevent them from qualifying for a mortgage, thus making home ownership impossible, at least temporarily. Only time will tell how much mortgage interest rates will rise. For now, the triple threat of high home price appreciation, limited supply and higher (and rising) rates will continue to reduce affordability. Thanks, inflation.
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