Will Higher Rates Create The Next Housing Bust?

Early warning signs suggest values in hot markets are getting stretched, and increased mortgage rates will send some areas into overvalued territory.

housesIn May and June of 2013, worries over Fed policy caused mortgage rates to jump approximately 75 basis points in 36 days. Prior to that, the housing market especially in places like California was blazing hot. Wall Street investors had kick-started the housing recovery in early 2012, and by the time would-be homebuyers caught on late in the year to the fact the inventory of foreclosed homes was disappearing, the scramble was on. Buyers finally seemed to recognize the gift of lower interest rates, and multiple offers meant listings lasting only for days were common.

When rates jumped, the housing market came to a screeching halt. Buyers, who had been shopping for homes on the assumption they could finance at 3.50%, suddenly faced rates of 4.50% and retreated. Fortunately, there were few homes on the market and prices did not fall sharply; they merely flattened out and remained flat for most of 2014 (with the exception of the San Francisco Bay Area, which apparently has buckets of gold for the taking on every street corner).

Mortgage rates briefly fell again to 3.50% in late January of 2015 and stayed below 4.0% until mid-May. Since summer, rates have rolled between 3.75% and 4.25%. This is not dramatically different from the beginning of the year, but what will happen if rates do rise?

A rise in rates will obviously affect monthly payments, as demonstrated by the table below.

$225,000 mortgage $417,000 mortgage $650,000 mortgage
3.50% $1,015 $1,873 $2,919
4.50% $1,140 $2,112 $3,293
5.50% $1,278 $2,368 $3,691

So, where is the pain threshold for buyers? Of course, there is no simple answer.

In 2013, the level was just below 4.50%, but there was also a shock value at work because of the suddenness of the rise.

In California, where home prices are high, buyers will feel the impact at 4.50%. Buyers in less costly markets will likely have a higher threshold. This won’t be a concern if rates don’t rise, but if mortgage rates vault higher than 5%, for example, are home values doomed? As lenders, should credit unions be worried?

Home prices for most areas are close to if not higher than their 2006 peaks. So what’s to say current conditions won’t result in the 2016 version of the 2006 bubble? Here are just a few reasons home prices are more likely to flatten out or slightly decline rather than hit the skids.

Let’s start with supply.

The newer homeowners have a lot of skin in the game.

When home prices started to roll over in 2006, there were approximately 4 million homes on the market. There are roughly 2 million for sale today. Now think about future supply. Everyone who has bought or refinanced a house in the past four or five years has an extraordinarily low mortgage rate. Unless a life situation forces a sale, homeowners won’t be eager to trade in a 3.75% mortgage for a 5.75% one.

More importantly, buyers from 2010 to 2015 were not like buyers from 2002 to 2006. The newer homeowners have a lot of skin in the game. They paid minimum down payments of 20%. Competitive markets required a down payment of 30% or all cash to attract a seller’s attention. This generation of buyers has too much at stake to walk away just because they see home prices retreat.

California has a history of real estate booms and busts. I think the odds are high that home prices in California have crested. Prices are not likely to tumble. More likely, they’ll flatten out or rise by 4% at most. Your market might have more room to run, but there are other Californias out there.

The affordability measures I watch are flashing some early warning signs that values in many hot markets are getting stretched, and any increase in mortgage rates will send some areas into overvalued territory that rivals 2006. But, unless some significantly negative economic event accompanies higher rates, today’s homeowners have enough at stake to hunker down and ride the wave rather than be sucked down in the undertow.;

Dwight Johnston is the chief economist of the California and Nevada Credit Union Leagues and president of Dwight Johnston Economics. He is the author of a popular commentary site and is a frequent speaker at credit union board planning sessions and industry conferences.

November 4, 2015

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