Mortgage interest rates have jumped by more than 2 percentage points since the end of 2021 and sit at 5.10 percent as of April 28, 2022. Mortgage payment amounts have also risen—from $1,283 on a $300,000 home at the end of 2021 to $1,629 on the same home, a 27 percent increase.
High mortgage rates compound affordability challenges as home prices remain high and price appreciation remains robust. One might expect sharply higher rates to slow home price appreciation to below-average levels in the coming months. Although we do expect home price appreciation to decline from the almost 20 percent over the past year, we believe it will remain above its more-than-45-year average of 5.1 percent.
How do mortgage rates, inflation, and home price appreciation interact?
Since 1976, mortgage interest rates and home price appreciation have had a positive but weak relationship. That is, higher mortgage rates tend to occur alongside higher home price appreciation, but it is a weak tendency.
So why do we expect home price appreciation to remain robust in the face of such affordability challenges? Because higher mortgage rates, and higher interest rates more generally, have historically been associated with periods of stronger economic growth, higher inflation, lower unemployment, and stronger wage growth. And the causality goes both ways. The Federal Reserve has historically raised interest rates when inflation or growth is higher than desired, so higher inflation, stronger economic growth, lower unemployment, and stronger wage growth have been associated with high home price appreciation.
To visualize how inflation and home price appreciation are related, we measured personal consumption expenditures against home prices. We found that a higher inflation rate is associated with higher home price appreciation and that the association is stronger than that between mortgage interest rates and home prices.
Quickly rising interest rates tend to slow home price appreciation
The historical relationship between mortgage rates and home prices does not address how home price appreciation changes when interest rates rise quickly.
Mortgage rates in the United States have declined since 1976, so there have been few periods when interest rates have increased more than 1.5 percentage points year over year. Two periods during which rates rose rapidly were from September 1979 to March 1982 and from September 1994 to February 1995.
During these periods, the rate of home price appreciation decelerated rapidly. From September 1979 to March 1982, home price appreciation decelerated from 12.9 percent to 1.1 percent. And from September 1994 to February 1995, it decelerated from 3.2 percent to 2.6 percent. For each period, real home price appreciation (home price appreciation corrected for inflation) was negative for some part of the period, but nominal home prices did not turn negative until a recession was under way.
In general, a stronger economy and higher inflation can support home price appreciation for several reasons. Higher wages and a lower unemployment, consistent with economic growth, will boost housing demand. Potential homeowners can reasonably expect rents will rise at least as fast as inflation (or faster, if demand is strong). If you buy a home, you lock in the largest portion of your housing costs, limiting the impact of any future rental rate increases and relieving pressure on your purchasing power.
Moreover, even if homeownership costs for new homeowners are initially higher than rental costs, prospective homeowners might buy anyway because inflation changes the math. Potential homebuyers see the mortgage payment they would lock into today as more attractive than future rental payments, which include rent increases. Investors are also willing to pay more, as they can expect higher rental income and lock in their financing costs.
Higher home prices may be here to stay
There has been a lot of speculation, but little evidence, about what higher rates tell us about home price appreciation. Our look at the historical evidence shows that sharply higher mortgage rates tend to slow home price appreciation and may weigh on housing market activity. But nominal home price appreciation does remain positive. And during these periods of sharp interest rate increases, we did not have the acute housing supply shortage we have today, which could slow the deceleration in home price appreciation. In short, despite a sharp drop in affordability because of higher mortgage rates, home prices are unlikely to decline. Rather, affordability challenges are likely to persist.
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