Home Buyers Are Facing a Triple Threat

It’s little secret that inflation currently poses a significant headwind to households, businesses, and the broader economy. The Consumer Price Index, which represents the average price of a basket of consumer goods and services, increased nearly 8% from February 2021 to February 2022. (Since January 1948, the year-over-year change in the CPI has averaged 3.48%, including double-digit YOY growth in the 1970s and 1980s.) As the rate of growth in the CPI increases, consumers’ purchasing power decreases. Simply stated, your dollar doesn’t stretch as far, so you must spend more money to buy the same goods and services, leaving you with less residual income for savings or discretionary items. 

To combat inflation, the Federal Open Market Committee decided on Wednesday to raise the federal funds rate, the interest rate at which depository and financial institutions (that is,  banks) lend additional reserves to each other overnight. It was the first time Fed policymakers had raised the rate since 2018. After hovering between 0% and 0.25%, the FOMC elected to initiate a one-quarter percentage point increase in the fed funds rate, which now hovers between 0.25% and 0.5%. Experts anticipate six additional rate hikes this year alone (each of one-quarter percentage point), which would leave the fed funds rate between 1.75% and 2% by the end of 2022.

Why does the increase in the fed funds rate matter to potential home buyers? In short, the mortgage interest rate loosely tracks the fed funds rate. (“Loosely” because relationship is intermediated by the 10-year Treasury yield.) As the rate increases, the cost of borrowing capital, or the interest rates for credit card loans, car loans, student debt loans, and yes, mortgage loans, will also increase. This reduces household demand for big-ticket items typically financed by debt, such as cars, homes, and college educations. And most home buyers—87%, according to the National Association of Realtors—use mortgage financing to purchase a home.

Even prior to the announced rate hike, mortgage interest rates were climbing, largely in response to rises in the 10-yield Treasury yield. After reaching a record low of 2.65% in January 2021, the average rate for a 30-year fixed rate mortgage topped 3.92% in mid-February before declining to 3.85% in early March (The average rate has since risen to 4.16%). At the beginning of the year, many forecasts indicated mortgage interest rates would hover around 4% by the end of 2022, but predictions will likely be adjusted upward in response to the Fed’s signal of seven rate hikes in 2022. (It was more common to expect four or five rate hikes earlier in the year.) 

Mortgage interest rates play an integral role in a household’s ability to purchase a home. As the rate increases, the total monthly mortgage payment also increases. That payment is known as “PITI,” for principal, interest, and property taxes and insurance. Assume the typical buyer puts 80% down on a 30-year, fixed-rate mortgage, and pays property tax and insurance equal to 4% of the home price. For a buyer with a conventional mortgage loan, the total monthly mortgage payment for the median-priced home in 2021 ($353,400 according to the National Association of Realtors) amounts to $2,317 at a rate of 2.65%, $2,387 at a rate of 3.11%, and $2,503 at a rate of 3.85%. In other words, the 1.2 percentage point increase in the mortgage interest rate from 2.65% to 3.85% increases the total monthly mortgage payment for the median-priced home by nearly $200, or over $2,200 per year. The effect of an increase in rates on the total monthly mortgage payment is smaller for lower-priced homes and larger for higher-priced homes.

As the total monthly mortgage payment increases, the required income to qualify for a mortgage loan also increases. With a mortgage interest rate of 2.65%, a home buyer seeking a conventional loan would need a qualifying income of nearly $93,000 for the median-priced home in 2021. However, that income increases to nearly $95,500 with a rate of 3.11%, and to just over $100,000 with a rate of 3.85%. The 1.2 percentage point increase in the rate from 2.65% to 3.85% represents a nearly $7,500 increase in the required income to qualify for a mortgage loan. As with the total monthly mortgage payment, the effect of an increase in rates on the required qualifying income is smaller for lower-priced homes and larger for higher-priced homes.

As the mortgage interest rate increases, the maximum home price affordable to a household declines. With a mortgage interest rate of 2.65%, a typical buyer with a conventional mortgage loan could purchase a home 3.81 times household income. For example, a buyer with a household income of $100,000 could afford a maximum home price of $381,000 with a rate of 2.65%. A household could afford a maximum home price of $353,000 with a rate of 3.85%, a decline of nearly $30,000, or 7.3%.

In an era of record high home price appreciation, a decline in purchasing power will prove more acute to all households, but particularly to lower-income and first-time home buyers, who already face constraints with respect to income, wealth, or credit (and often all of the above). For households on the margin, or potential home buyers who barely meet the criteria to qualify for a mortgage loan, an increase in mortgage interest rates could push them into “unaffordable” territory. In other words, it could leave them unable to qualify for a mortgage loan, thereby making homeownership unattainable, at least temporarily. Only time will tell how much mortgage interest rates will rise. For now, the triple threat of high home price appreciation, limited supply, and higher (and rising) rates will continue to diminish affordability. Thanks, inflation.

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