Rising Mortgage Rates Pull Back The Curtain On Emerging Local Bubbles

As mortgage interest rates climb, the local bubbles that have quietly been inflating in a number of markets will reveal themselves.

Between 1985 and 2000, the monthly mortgage payment on a typical American home (after 20 percent down) represented about 20 percent of monthly median household incomes. By the end of 2012, that had fallen to roughly 12.6 percent. Thanks largely to a combination of a big dip in home prices during the recession and historically low mortgage rates, Americans were spending 37 percent less of their monthly salaries on mortgages at the end of last year.

But recently, mortgage rates briefly crossed the 4 percent threshold, and are expected to continue to rise, slowly but steadily. So we set out to discover those areas in which affordability will be most affected once mortgage rates hit 5 percent, 6 percent and 7.1 percent. The 7.1 percent threshold is the point at which homebuyers nationwide will be back to spending 20 percent of their monthly incomes on a mortgage payment.

At current mortgage rates, on a monthly payment basis, the U.S. as a whole and all of the top 30 largest metro markets covered by Zillow are more affordable today relative to their historic norms.

But at 5 percent mortgage interest rates and assuming homes in these metros appreciate in line with Zillow’s Q1 2013 home value forecasts, homes in half a dozen markets will look more expensive than their historic norms on a monthly payment basis: San Jose, Calif. (22 percent more expensive); Los Angeles (19 percent more expensive); San Diego (14 percent more expensive); San Francisco (11 percent more expensive); Portland, Ore. (7 percent more expensive); and Denver (1 percent more expensive).

At 6 percent, five more major markets become more expensive: Riverside, Calif. (11 percent more expensive); Miami (7 percent more expensive); Seattle (5 percent more expensive); Sacramento (4 percent more expensive); and Washington, D.C. (2 percent more expensive). And, logically, the six markets that were more expensive at 5 percent only look even pricier at 6 percent. In San Jose, for example, at 6 percent mortgage interest rates, homeowners can expect to pay 36 percent more of their monthly salaries on mortgage payments than they were paying between 1985 and 2000.

At 7.1 percent mortgage rates, the point at which homeowners in the U.S. as a whole are back to spending their monthly historic average on mortgages, homes in another 7 large metros fall into the more expensive bin: Phoenix (13 percent more expensive); Boston (10 percent more expensive); Philadelphia (9 percent more expensive); New York (7 percent more expensive); Baltimore (6 percent more expensive); Pittsburgh (5 percent more expensive); and Charlotte (2 percent more expensive).

Yes, rates will remain very low for at least the time being. But it won’t be long before they climb back to 5 percent. Consider some historical context: The average 30-year fixed rate mortgage rate over the past 42 years is roughly 8.5 percent, according to Freddie Mac. In other words, rates of 5 percent or 6 percent should still be considered bargains, historically speaking.

And when (not if) they reach that point again, we’re likely to see price volatility, as consumers are forced to either spend more of their incomes to buy ever more expensive homes; or home value appreciation will stagnate or fall while waiting for incomes to catch up.Cory_MapGraphic_c_574px