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Will Rising Interest Rates Kill The Real Estate Market?

February 22nd, 2010 by Gary Lucido

Understanding the relationship between interest rates and home prices is particularly important now because most people believe that interest rates are heading up in the not-to-distant future. One might quite logically expect that when mortgage rates rise it depresses home prices. After all, most people determine the affordability of a home by looking at the monthly payment. In fact, buyers and their lenders usually target their price limit based upon how much they can afford to pay in principal, interest, taxes, and assessments, given their income. And the interest component of that equation is a big driver of the size of the payment. So when interest rates rise you would expect that all buyers would have to shift their expectations down scale and that this would depress home prices.

However, about a month ago one of my clients sent me a link to a BusinessWeek article on the impact of interest rates on home prices. In this article the author, who is the founder and president of Home Warranty of America, claims that the data just doesn’t support the notion that rising interest rates depress home prices. Although he doesn’t provide the direct analysis in his article he does provide links to several data sources so that you can do your own analysis. However, I would like to point out that this is not the first time I’ve heard this claim and I myself have glanced at the data before and found this to be true – especially in the late 70s and early 80s, which is the time period referenced by this author. During that time period home prices rose, despite interest rates that approached 18% ?!?!?! Or at least home prices didn’t decline like you would have expected.

Well, last week a spirited debate transpired on Cribchatter about this very topic. This has to be one of the longest threads in Cribchatter history with 234 comments. The people who argued that higher interest rates would push home prices down were initially arguing based upon the same logic I articulated above. However, eventually both sides of the debate started to link to various studies and articles that proved their point of view. Like most academic endeavors, when someone makes a career out of spending grant money they can prove anything they want so it’s not surprising that there are plenty of studies to support either side. Personally, I got a headache from following the debate, not to mention that it was full of insults.

However, I would like to point out a few things:

  • Many of the articles referenced as proof that higher interest rates depress housing prices were nothing more than opinion pieces, based upon financial logic, or were based upon anecdotal data. Hardly real studies. Nevertheless, several legitimate studies were referenced to support this thesis.
  • There could be several logical explanations as to why higher interest rates would not depress home prices as expected:
    • Buyers assume they can refinance at a lower rate in the future
    • Buyers have other financing alternatives, including adjustable rate mortgages and higher down payments. (I remember buying our first home in the summer of 1984 and an ARM was a no-brainer.)
    • Higher interest rates are usually associated with inflation and inflation pushes up housing prices
    • Buyers assume that if interest rates are higher now they will go down in the future and that will elevate home prices
    • When rates go up buyers shift their focus to the lower end of the spectrum but demand at every price level is replaced by demand shifting down from a higher price level – except of course as you get to the higher levels there isn’t as much replacement demand as exiting demand
    • When rates go up buyers simply allocate more of their income to interest payments.

For further reading you may want to check out some of the referenced studies and one that I have been meaning to read for a while:

  • What Moves Housing Markets – demonstrates that interest rates do not affect home prices. “…our results provide evidence that changes in risk-free interest rates may not have done much to change housing valuations over the 1975 to 2007 period.”
  • The Effect of Real Rates of Interest on Housing Prices – demonstrates that real interest rates do affect home prices. “This ebb and flow of real interest rates appears to explain market price levels.”
  • Assessing the Role of Income and Interest Rates in Determining House Prices – demonstrates that interest rates do affect home prices. “Our results support the existence of a long-run relationship between actual house prices and the amount individuals can borrow.”
  • Why do House Prices Fall? – demonstrates that interest rates do not affect home prices. “Interest rates appear to play a relatively minor direct role, though they may play an important indirect role.”
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