For much of the past three decades, interest rates have trended continuously lower. Although there have been occasional spurts of rising rates, these tended to be short-lived. As a result, a generation of Americans has been able to buy larger homes without spending more on mortgage payments. Over the coming years, interest rates are poised to rise. Homeowners considering moving will have to decide whether to purchase smaller, less expensive homes or spend more on their mortgages. Some may decide instead to remain in their current home—a phenomenon known as fixed rate mortgage “lock-in.”

As part of its annual Housing Forum on July 24, 2014, Zillow convened experts to discuss their expectations for mortgage rates and residential mobility as interest rates begin to rise. The panel featured Michael Fratantoni, Chief Economist and Senior Vice President at the Mortgage Bankers Association (MBA); Christopher Thornberg, Founding Partner of Beacon Economics; Joseph Tracy, Executive Vice President and Senior Advisor to the President at the Federal Reserve Bank of New York; and Lawrence Yun, Chief Economist and Senior Vice President at the National Association of Realtors. The discussion was moderated by Nick Timiraos of the Wall Street Journal. Stan Humphries, Chief Economist of Zillow, delivered an introductory summary of the issue based on Zillow research on the topic.

The lock-in effect of financial frictions

Tracy pointed to two features of U.S. mortgages that can reduce mobility: (1) the absence of a requirement that home buyers maintain a minimum, positive equity stake in their homes, and (2) the lack of portability or assumability of most mortgage contracts in the U.S. (Loans insured by the Federal Housing Administration [FHA] are assumable and are an exception to this generalization.) His research finds that between 1985 and 2009, homeowners with negative equity sold their homes 30 percent less often.
As home prices have recovered, concerns about negative equity have receded. However, new frictions are emerging. Homeowners who obtained long-term fixed rate mortgages during the recent period of historically low mortgage rates will now confront higher financing costs if they decide to move. Tracy estimates that for every $1,000 in annual interest costs due to higher rates, the probability that a household will move falls by 16 percent.

Expected path of interest rates

Of course, the extent of lock in will depend upon how much interest rates increase. Forecasts of the path of interest rates over the next year vary substantially. Fratantoni and Yun see strong incoming macroeconomic data (and, in the case of Yun, inflation), forcing the Federal Reserve to raise short-term interest rates sooner than many expect, with rates rising to around or slightly above 5 percent by early 2015.

However, even if rates rise to around 5 percent, mortgage rate lock-in will not necessarily be a problem: Almost no households who move cite interest rates as a factor influencing their decision and about one-third of homeowners do not have a mortgage. By contrast, Thornberg believes that the Federal Reserve’s asset purchases have had a relatively modest impact on interest rates and that rates will increase very slowly, remaining below 5 percent through mid-2016. Global credit supply and demand dynamics will play a far more important role in determining mortgage rates than Federal Reserve policy.

Affordability

The discussion of interest rates naturally led to a conversation about affordability. Most panelists expect household incomes to start rising more robustly and for home price increases to moderate. However, they all noted that credit conditions remain historically tight. Since 2005, mortgage lending standards have swung from too loose toward too restrictive and have yet to moderate. In particular, buyers with credit scores between 640 and 720, the lower range of prime borrowers, remain largely on the sidelines of the housing market. Fratantoni observed that borrowers in these credit bins historically have comprised about 40 percent of the market, but currently account for around 15 percent.

Regulatory changes have also contributed to tight credit conditions. Fratantoni noted that the treatment of adjustable rate mortgage (ARM) loans under the Consumer Financial Protection Bureau’s (CFPB) new Qualified Residential Mortgage (QRM) regulations means that 1-year ARMs no longer enhance affordability like they historically have. Similarly, Yun noted that recent increases to FHA mortgage insurance fees have priced many low-income borrowers out of the market. While FHA fee increases were intended to build the agency’s capital reserves due to higher than expected losses on its existing portfolio, this may inadvertently burden new borrowers who will have to pay for FHA’s past mispricing of risk.

Inventory

One defining feature of the current housing recovery is that home price increases have been driven by low supply rather than by strong demand. Panelists pointed to two explanations for current low inventory: (1) the residual effects of high negative equity during the crisis, and (2) a lack of new construction.

As house prices recover, the number of households with negative equity should decline. Some of these households may have delayed moving until recovering their initial home equity, and may start coming onto the housing market leading to higher inventory. Some may have temporarily rented their homes as an interim solution—contributing to the phenomenon of “accidental landlords”—and may opt to sell.

Instances where lock-in may already be occurring

While most panelists dismissed the idea that fixed mortgage rate lock-in will be a serious challenge—at least in the near-term—they also pointed to two more narrow scenarios where variants on lock-in may already be occurring: (1) cash-out refinancing, and (2) if Congress enacts changes to the capital appreciation tax exclusion on residential home sales.

Fratantoni expects that rising interest rates will more dramatically dampen cash-out refinancing, which have historically been used by households to finance major home renovations or educational expenses. Instead, borrowers will likely turn to second mortgages or home equity lines of credit to leverage their accumulated home equity for these major investments.

Yun also pointed to proposed legislative changes to the capital gains tax exclusion on home sales, which would increase the number of years a homeowner must use a home as a primary residence in order to qualify for the capital gains tax exemption, and which Yun believes would dramatically reduce residential mobility. Currently, homeowners must reside in their home two out of five years in order to avoid paying taxes on capital gains from the home sale. Under tax reform legislation proposed in the House of Representatives earlier this year, the exclusion would only apply to homeowners who have used the home as a primary residence for five of the prior eight years.