Will Rising Interest Rates Bring the Curtain Down on the Housing Recovery?

Home mortgage interest rates hit a two-year high last week, soaring from 3.93% during the week of June 17 to 4.46% last week – the biggest one-week jump in rates in 26 years.  And the rise in rates since the winter lows of 3.25% – 3.375% has had a striking effect on monthly mortgage payments: a $250,000 mortgage at 3.37% back in April would have had a payment of just $1,102/month.  The same $250,000 mortgage at 4.46% would be $1,256/month, a $154 difference.  And now, after months of exuberance, Realtors, mortgage brokers, market analysts, and housing economists are debating the question whether the rate rise is going to weaken the housing recovery, or kill it outright.

Here’s the back story, in brief.  Interest rates took a hit – and the stock market did too – when Fed Reserve Chairman Ben Bernanke said that the Fed, in light of continuing signs of the economic recovery, may begin scaling back on its bond-buying stimulus program later this year.  Mortgage rates trend along the same track as the yield on the 10-year Treasury bond, so a cut in the Fed’s buy-back will cause the yield on bonds – and mortgage interest rates – to rise.  If the Fed cuts buying, interest rates will rise.  And the consensus among bond dealers and Wall Street is that’s what the Fed’s going to do.

Here’s a look at the housing market, in brief.   Since last fall buyers seeking to take advantage of low rates have been competing among themselves for a very tight inventory of listings. Prices have been driven up by the competitive pressure and fueling the strongest housing market since 2006.  House prices in 20 U.S. cities rose 12 percent in April, the biggest year-over-year gain since March 2006, according to S&P/Case-Shiller data released this past week.  In the Portland area, Case-Schiller reported prices rose 2.1 percent in April and 12.9 percent compared with a year ago.  That trend has persisted through May and into June.  With news of the Feds’ proposal a number of market watchers switched last week from a sunny sanguine view of the housing recovery to grim predictions of the demise of the market and the end of the housing recovery.

While prospects for any drop in interest rates are dimming, there are a number of factors which will help moderate the increasing cost of buying a home, and sustain the market recovery.

Buyers have faced rising interest rates in the past and they – and the market – have survived.  From the financing view, two important trends are developing which will help support buyers’ buying power, and moderate the effect of rising interest rates:

  • Adjustable rate mortgages, long out of favor, will bounce back and give buyers a low-cost alternative to the higher rates that fixed rates impose on them.
  • Bank credit standards have been loosening for more than two years, allowing more and more buyers sidelined by low credit scores, limited income, and even bankruptcy to have a chance to qualify for a mortgage now and come into the market.

Rising inventories of homes will partially dilute buyer demand. While low interest rates have been partially responsible for the price climb, low inventories have been the rates’ accomplice.  But there are trends developing that suggest inventories will begin to accumulate in the coming months, and with that accumulation buyer demand – and prices – may move to sustainable growth levels.

  • Bank foreclosures came to a near standstill this year while the State Supreme Court debated whether the big banks’ uniform foreclosure practices were legal.  In Oregon the Mortgage Electronic Registration System (MERS) litigation was partially settled in June, and in favor of the big lenders.  The rulings will open the way for banks to resume their so-called “non-judicial” foreclosures and the effect will be an increasing number of bank-owned properties coming to the market.
  • Rising housing prices have helped home-owners who’ve been underwater for years reach the point they can finally sell.  These home owners, members of the “Shadow Inventory” that we’ve written about in the past, are ready, willing, and finally, able to sell.  There is a 5-year backlog of homeowners who have been waiting for the opportunity to sell, and as the weeks and months pass we’ll see more of their homes come into the inventory.
  • The once-moribund home-building industry has taken off for the first time since 2006 – 2007.  Look in practically any neighborhood in Portland to see new homes coming out of the ground. And while these homes typically have higher price points than re-sale homes – people will pay a premium for “new” – the overall effect of more new homes will dilute inventories.

Earlier this year we wrote that the market’s course in 2013 would be set by interest rates and inventories.  We think that a rise in interest rates will not suppress buyers’ appetites for buying a home.  For one, interest rates, we remind ourselves, are still so very very low.  And for another, as we remark here, looser credit standards and adjustable rate alternatives will help maintain buyers’ ability to buy into the market.

It’s our opinion that the markets’ direction through the end of the year will be governed by inventories, and not interest rates.  While we’ve pointed to evidence that inventories will begin to rise from their recent near-historic lows, we believe that the rise will not satisfy buyer demand for many months ahead of us.  We’re not concerned that rising interest rates will “kill” the market.  In fact we welcome both emerging moderating trends – rising interest rates, increasing inventories – in the hope they’ll bring the market back into a sustainable balance between buyers and sellers in the coming months.  Just as much as we welcome sunny summer weather, we – and the housing market – also need a little respite from the heat.