Higher Interest Rates and Residential Real Estate Markets - What Would Happen?

A key factor impacting the fundamental value of housing and thereby the bottom is interest rates. Higher interest rates would devastate residential real estate markets. When interest rates go up, the amounts borrowed go down assuming a consistent payment. As amounts borrowed go down, so do real estate prices.

Interest rates went down during the price decline in the early 90s. That softened the impact and made the decline take somewhat longer. When interest rates are declining, bubbles take longer to deflate, and the bottom is at a somewhat higher price point. When interest rates are increasing, bubbles deflate faster, and the bottom is at a lower price point. Mortgage Interest rates during the housing bubble were at historic lows so a repeat of the steady decline in rates witnessed during the 90s is not very likely. Higher interest rates translate into diminished borrowing, lower prices and a lower bottom.

The lowering of the FED funds rate to 1% during the bubble prompted the lowering of mortgage interest rates to 5.8% by driving down the yield on the 10-year treasury bill. The difference between the 10-year treasury bill and mortgage interest rates is due primarily to the risk premium which was near historic lows during the great housing bubble. As lenders and investors in Mortgage Backed Securities (MBS) lost money during the decline, they demanded higher risk premiums. This increased the spread between the 10-year treasury bill yield and mortgage interest rates. The spreads for jumbo and subprime both became larger, and the funding for many exotic loan programs dried up.

As the FED lowered interest rates, the increased risk premiums demanded by lenders and MBS buyers drove up mortgage interest rates along with the heightened inflation expectation the lower FED funds rate caused during the cycle. Unless the FED wants to start paying people to borrow by lowering rates below 0%, base rates cannot go much lower. If all three parameters that make up mortgage interest rates were at historic lows during the bubble rally, there was little or no hope of mortgage interest rates falling below 5.8% in the bubble's aftermath. The combination of a higher FED rate, higher inflation expectations and larger risk premiums could easily push interest rates back up to near the 8% historic norm or even much higher. An increase in interest rates from 6% to 8% would reduce buying power 18%, and an increase to 10% would reduce buying power 32%. This would be disastrous for housing prices.

Mortgage interest rates have been on a slow but steady decline since the early 1980s. Interest rates were at historical highs in the early 80s to curb inflation, and the decline from these peaks to the 7% to 9% range was to be expected. This initial decline in interest rates coupled with low inflation caused house prices to begin rising again in the late 80s culminating in the bubble that burst in 1990 leading to six consecutive years of declining prices.

During the early 90s while prices were declining, interest rates were also declining from 10.6% in 1989 to 7.2% in 1996. These 30% declines in interest rates made housing more affordable and helped limit the price declines in the early 90s. If interest rates had not declined, house prices certainly would have dropped further than they did. It is not very likely that interest rates will decline 30% from the 5.8% they were during the bubble down to an unprecedented 4.1% to match the debt relief of the early 90s. The FED policy of quantitative easing is designed to reduce long-term interest rates, and they may drive home mortgage rates down to 4.5%. However, the actions of the FED could not and did not keep house prices from falling. The best they can do is to control the implosion.

At some point, interest rates will have to go up. The only questions are when interest rates will rise, how quickly they will go up, and how high they will go. These answers will depend on inflation and the FEDs response to it. The housing bubble had an enormous impact on the broader economy.

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