Rising Interest Rates: At 4.9 percent (as of Nov. 15, 2018), the 30-year mortgage interest rate is at its highest level since April 2011. What is the impact on housing demand?
We have been expecting a slowdown in home sales and home price growth due to rising rates and it looks like it has finally arrived. We are seeing some cooling of the housing market, a trend particularly pronounced out west. For example, pending home sales in San Francisco fell 10 percent from the year before1 and both Seattle and Denver slowed noticeably.
Even with this slowdown, in most cities it remains a seller’s market and we are not overly concerned. An overheated market is just moving closer to normal levels. Job growth remains strong and mortgage rates are still on the low side: More than 80 percent of the time, since 1970, the rates for fixed-rate mortgages have been higher than today’s rates.
The recent jump in mortgage interest rates, combined with worsening affordability, are behind the recent cooling. Higher rates are in line with our forecasts, which project an average mortgage rate of between 5.0 and 5.25 percent next year. Rising rates have historically caused a mild slowdown in transactions, slowed home price growth and resulted in a large reduction in refinances. One estimate of the size of the typical impact of higher rates comes from J.P. Morgan researchers2 – they found that each rate increase of 0.25 percent trims homes sales by roughly 2 percent.
Are you seeing home prices flatten or decline? How much further do interest rates have to rise before we see price declines in housing? Which factor is more important for home prices – unemployment or interest rates?
Home price growth slowed in Q2 and declined modestly in a few very expensive markets, such as Hawaii, San Jose, California, and Washington, D.C., due to affordability issues. A mild deceleration in sales and Home Price Index (HPI) growth is actually healthy because it will help calm excessive price growth, which has pushed some markets into overvalued territory, and produce a more balanced situation. Price growth has been too strong for several years, fueled in part by abnormally low interest rates.
The recent bump in mortgage rates will result in continued cooling over the next few months, but outright price declines are unlikely in America’s largest markets unless rates reach 6 percent or higher. We expect national home prices to continue to grow 2 to 4 percent a year as long as we continue to have a constrained housing supply and ample job opportunities. For one thing, construction has been too low over the past five years and housing inventory is exceptionally lean, especially at the entry level. Also, the latest results of the Arch MI Risk Index®, a statistical model based on nine indicators of the health of local housing markets, estimates that the overall probability of home prices being lower in two years is 6 percent. That is much better than the historical average of 17 percent.
While rate changes cause some people to temporarily hold off from buying and drives some people out of the market, in the long run employment is the key driver of housing demand.
What is Arch MI’s outlook for mortgage rates?
Our forecast is for continued gradual rate increases, similar to those from the GSEs and the MBA.
Of course, the direction and pace of interest rate increases depends on future inflation, policy changes, economic and financial market conditions, and even events overseas. Nevertheless, at the moment, rates are likely headed higher, given the following:
- The Federal Open Market Committee raised the funds target rate by 25 basis points in September for the third time in a year. Its Summary of Economic Projections forecasts that economic growth will remain strong and the unemployment rate will trough at 3.5 percent in 2019 and 2020, a full percentage point below its estimated natural rate. The Federal Reserve (the Fed) also projects inflation to be around its 2 percent target and its federal funds rate projection implies another rate hike in December.
- The federal government’s budget deficit is rising quite rapidly, increasing the supply of U.S. Treasury bonds (which, all else remaining equal, lowers bond prices and increases interest rates).
- The Fed is gradually reducing its purchases of Agency Mortgage-Backed Securities (MBS) to replace run-offs – this may increase mortgage rates by roughly 0.25 percent over the next few years.
What is the impact of government policy changes?
It’s mixed. Strong government spending and tax cuts are helping to create a strong economy, but also increasing interest rates. Other factors are having a relatively minor impact on housing.
- Deficit spending is putting upward pressure on interest rates.
- The impact on housing of changes in the tax law has been minor so far.
- Over time, the higher marginal cost of owning both primary and secondary homes will likely result in slightly lower home ownership rates and slightly lower home price growth.
- Infrastructure. Nothing yet. It will be a positive if Congress does act. Overcrowded transit is one reason cities are not expanding outward as fast as in the past.
- Trade war. A negative for housing in two ways: It increases overall inflation, which tends to push up interest rates, and it increases the cost of building new homes. Impacts vary by region and by type of employment, but are generally not helpful in the short run. Higher construction costs due to tariffs on lumber, steel and other materials may slow construction. Tariffs are discussed in detail in the Spring 2018 HaMMR℠.
Is declining affordablity going to kill the housing market?
Housing affordability varies greatly by location. It remains favorable to home ownership in most locations but is deteriorating quickly as rates rise. The National Association of Realtors® Affordability Index is still 15 percent better than its historic average for the U.S. overall, which may explain why GSE data indicates an increasing first-time homebuyer share and the home ownership rate last year grew for the first time in 13 years.
Chart 1: Housing Affordability Index
At Arch, we also create our own affordability measure, based on the percentage of median household income needed to cover mortgage payments on a median-priced home (assuming a 10 percent down payment), as shown below. More details about our Median Debt-to-Income ratio can be found in the latest HaMMR.
Chart 2: Percentage of Median Household Income Needed to Cover Mortgage Payments on a Median-Priced Home
What is Arch MI’s view on the increasing credit risk by region?
Arch has several proprietary risk measures that we make public on our website, including the Arch MI Risk Index and our estimates of over-/undervaluation.
HaMMR also discusses regional risks. In the Fall 2018 issue, Alaska, West Virginia, Texas and Connecticut rank as the highest in risk, but are still relatively modest risks.
Alaska has the highest Risk Index value, with a 26 percent chance of seeing house price declines. The state’s Risk Index value decreased from last quarter due to a slight improvement in home price growth. Alaska and West Virginia make the list for highest-risk states due to the lingering effects of slowdown in the energy-extraction sector. They are both on track to improve and the worst appears to be behind us.
Home prices in Texas continue to grow faster than incomes do, which is not sustainable. Texas is likely to become riskier going forward since affordability continues to deteriorate at a rapid rate and it is easier to build there than in most states. We estimate that Texas has an 18 percent chance of house prices being lower in two years due to high home prices relative to its past.
Connecticut has a 15 percent chance of price declines since it is a high-cost, high-tax state, which may suffer disproportionally from new limits on state and local tax deductions.
Chart 3: State and Metros with the Highest Risk Index Values
Chart 4: Arch MI Risk Index for the 25 Riskiest MSAs