Why Rising Mortgage Rates Don’t Really Matter

After years of low mortgage interest rates, they’ve finally begun to rise. As of the end of October 2018, rates are up to 4.85%.

Image: ycharts.com

Realtor.com expects rates to average out to 4.6% for 2018 and reach 5% before the end of the year. Freddie Mac expects about the same.

We’ve enjoyed historically low mortgage interest rates for some time now, so it’s no surprise that the market has begun to trend upward. Rates can’t stay low forever.

If you’re a mortgage originator, this trend has likely sent you into a panic. Won’t fewer people seek to buy homes (whether due to inability or lack of interest)? Won’t it be harder to qualify borrowers for loans? Is there even a future in mortgage origination in the upcoming market?

Let us put your mind at ease: Rising mortgage rates don’t really matter.

Rising Rates Mean a Stronger Economy

The economy has been growing rapidly for several years now. During the recovery, the Federal Reserve kept the federal funds rate low so banks could lend capital to one another inexpensively in order to promote growth.

When economies grow, inflation tends to rise too, which is what we’re seeing now and one of the reasons the Federal Reserve has begun to raise rates. Combating inflation is part of its core mission.

The Fed is expected to continue increasing interest rates for the foreseeable future. Goldman Sachs Chief Economist Jan Hatzius says the Federal Open Markets Committee will raise interest rates once each quarter until 2019.

When the Fed raises rates, financial institutions bear more costs associated with lending, so they pass those costs down to borrowers. Personal loans, auto loans, lines of credit, and – of course – mortgages become more expensive.

But even though mortgages become more expensive when rates rise, personal incomes tend to rise as well in a growing economy. The numbers may be bigger on both sides of the equation (loan cost and income), but the mortgage represents the same portion of the borrower’s purchasing power.

“If interest rates are rising because the economy is growing more rapidly, then, typically, incomes also rise, and the rise in incomes offset the increase in the size of the mortgage payment, and housing goes just fine,” says Doug Duncan, chief economist at Fannie Mae.

Rising Mortgage Rates and the Buyer’s Ability to Borrow

There’s a common misunderstanding that rising mortgage rates affect the borrower’s ability to take out a mortgage, but interest rates have nothing to do with the qualification process.

The qualification process is a function of the borrower’s income and debt profile measured against a preset standard which includes the prospective monthly mortgage payment. Interest rate isn’t a part of that equation at all.

However, interest rates do affect borrowers’ purchasing power. Lower interest rates mean borrowers can take out larger loans without increasing their monthly mortgage payment.

You’ve surely made these calculations yourself. Knowing the borrower’s down payment and closing cash, any loan officer can do quick math to determine a borrower’s maximum mortgage payment and loan amount – all without ever considering mortgage interest rates.

If mortgage rates affect purchasing power, doesn’t that mean some borrowers can’t buy the house of their dreams? In some cases, yes, but that rarely brings the buying process to a halt.

If you can’t approve a would-be borrower for a loan sufficient to buy their favorite home, their only options are to put more down, buy points, or choose a more affordable home. Borrowers who are only interested in one specific property are rare. Typically, borrowers narrow their home search to properties within their purchasing power once they get that figure from a loan officer (which is why it’s generally better for borrowers to speak to a loan originator before a realtor).

So while their choices may be limited, rising mortgage rates don’t prevent people from getting mortgages.

Rising Mortgage Rates and Home Prices

As interest rates increase, prospective homeowners’ purchasing power begins to shrink (as we discussed a moment ago). This means they’re forced to consider less expensive homes. Some buyers fall out of the market entirely.

When there are fewer buyers (at each purchasing level or at all), sellers are forced to reduce their asking prices if they intend to actually sell their property. We saw this phenomenon after the crash of 2008 when many people’s property value plummeted.

We’re seeing the opposite effect now: As interest rates climb and buyers gain more purchasing power, sellers can demand higher prices for their properties.

It’s true that house prices are rising and expected to climb for some time. According to the National Association of Realtors, home prices were up 5.9% nationally year over year as of February. Prices increased in every region. We can see this trend historically.

Image: bankrate.com

Homebuyers (and some loan officers) mistakenly think that if mortgage rates rise, home prices must fall, otherwise homes will become less affordable. But this relationship is – at best – indirect.

Why are house prices rising? It’s largely an inventory problem.

Rising home costs are attributed to a shortage of entry-level construction. Basically, building materials have become more expensive, so developers opt to build higher-end homes to recoup their costs. Entry-level homes and affordable housing don’t offer an attractive return, which creates a shortage of those options. Thus prices increase.

If inventory conditions were to improve at the lower end of the market, most home buyers wouldn’t ever consider rising mortgage rates.

Additionally, even though incomes are rising, real wage growth continues to lag behind home prices. In March, average hourly earnings were only up 2.7% year over year. This means people’s incomes aren’t growing as fast as home prices are increasing. To a lot of buyers, it feels like homes have become exceedingly expensive, but again – it has nothing to do with rising mortgage rates.

Other factors affect housing price changes as well, such as location, employment opportunities, cultural shifts, etc.

“A slow and steady rise in mortgage rates alone, such as what we’re seeing now, won’t be enough to impact housing prices,” says Adam DeSanctis, national media manager at National Association of Realtors.

In many cases, rising rates actually trigger purchasing. This is because buyers want to get today’s rate before it rises again. This is the classic fear-of-missing-out scenario.

“The fact that rates are rising actually causes demand—particularly first-time homebuyer demand—as they try to crowd into the market and lock in a mortgage rate and price before both go even higher,” says Mark Fleming, chief economist at First American.

This effect doesn’t just apply to people who are actively buying a home. News of rising rates can influence people who hadn’t previously considered buying. Rising rates can be quite the motivator. (You probably use this sort of language yourself to escort would-be buyers through the mortgage process.)

Buying a Home Is an Emotional Decision

Back in the 80s, mortgage interests rates rose as high as 18.5%. By today’s standards, that’s expensive for a credit card, let alone a mortgage.

And yet, people still purchased homes. There will always be buyers because people always want homes.

Few people think of their homes like a financial asset (even though it is). They think of it as a foundation for their life; a place to settle down and grow, and raise a family. Homes are places of comfort, safety, and community.

For most people, the timing of buying a home has almost nothing to do with mortgage rates, whether they’re increasing or decreasing. Most people buy a home when their other life factors align nicely, like when they’re in a stable job or ready to expand their family.

It’s true that people sometimes nudge their home purchase a little sooner or a little later to capitalize on better rates, but they rarely disrupt their lives to score an extra half percent on their mortgage.

Key Takeaway

If, like a lot of mortgage originators, you dove into the industry when rates were rock-bottom and the only thing you had to do to sell was pick up the phone, we say this: Don’t panic. Rising mortgage rates mean far less than many people tend to believe.

You may have to make some changes to your process and invest in some new tools (like the Market Alert suite of forecasting tools), but there will always be homebuyers.