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December 19, 2016

When interest rates go up in a healthy economy, history says home prices will rise

December 20, 2016

Since the election, mortgage rates have risen from 3.54 percent to 4.16 percent. What does this mean for home prices?

On one hand, rising interest rates mean higher inflation, which is good for real assets and should push up home prices. Rising interest rates also usually mean a healthy economy, which is good for wages, allowing borrowers to afford a higher mortgage payment.

On the other hand, rising interest rates reduce affordability, since fewer borrowers can make the higher interest payments.

Which effect dominates? Based on the historical evidence, it appears rising interest rates in a healthy economy generally produce higher home prices.

Looking at a 40-year history of 10-year Treasury rates and interest rates on 30-year fixed-rate mortgages, we see that after peaking in 1981, all interest rates declined dramatically.

Interest rates have dramatically declined

This long decline, punctuated with short periods of increases, gives us three periods to study the impact of rising interest rates on home prices.

1976–81: Rapidly rising rates and rising prices

Rapid interest rates increases between 1976 and 1981 made affordability a big issue.

Historically house prices rise when interest rates go up

To put these rates in perspective, the day before the 2016 election, a borrower who purchased a $233,300 home (close to the current median home price), putting down 10 percent and holding a $210,000 30-year fixed-rate mortgage at 3.54 percent, would have a monthly payment of $948.

If that same borrower had obtained a mortgage after the election, he or she would face a rate of 4.16 percent and would pay $1,022 each month. This payment represents 30 percent of today’s average annual earnings of $43,368

In the beginning of 1981, that same house would have been priced at $55,278 (based on CoreLogic home price indices); assuming the same 10 percent down, the borrower would have had a $49,750 mortgage. The mortgage rate would have been about 15 percent, and the monthly payment would have been $629. The average borrower would have been paying about 53 percent of his or her average annual earnings of $14,352 on the 1981 mortgage.

So today’s home values are 4.22 times as high as early 1981, while the nominal earnings of wage and salary workers are roughly 3 times as high and mortgage payments are only 1.62 times as high. That means today’s mortgage payments, measured as a share of wages and salaries, are close to half what they were in 1981. Even during this less affordable period of 1976–81, as high mortgage rates were inching even higher, home prices continued to slowly rise and never decreased.

1994 and 1999–2000: Rising rates and robust home price appreciation

As shown in the figures, mortgage rates also rose notably in 1994 and in mid-1999 to late 2000. In 1994, rates were about 200 basis points (2 percent) higher than the previous year. In mid-1999 to late 2000, rates were over 100 basis points (1 percent) higher than the previous year.

In both periods, home price appreciation was quite robust. In fact, the only nationwide period of home price decline other than the Great Recession was during the recession in the early 1990s.That said, real home price appreciation (home price appreciation corrected for inflation) tells a very different story. Figure 2 clearly shows that, in the early 1980s, home prices failed to keep up with inflation; as a result, real home prices fell substantially. In general, real home price appreciation turns negative when the economy is in a recession, but the period of negative appreciation lasts much longer than the recession.

A closer look at the long history of interest rate and home price changes seems to indicate that the state of the economy is the largest driver of home price changes. In a healthy economy, interest rate increases deliver home price increases, and the economy is relatively strong today. In addition, home prices have a further tailwind: very limited housing supply. All these factors lead us to believe that if interest rates continue to rise, so too will home prices.

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