A sustained upswing in mortgage interest rates is likely to be felt by current and would-be homeowners alike, denting mortgage affordability in many large markets and complicating the financial decision on when or whether to move to a different home.
A sustained upswing in mortgage interest rates is likely to be felt by current and would-be homeowners alike, denting mortgage affordability in many large markets and complicating the financial decision on when or whether to move to a different home.
Currently hovering around 4.3 percent for a standard, 30-year, fixed-rate loan, mortgage interest rates remain very low by historic standards, a silver lining in today’s ultra-competitive housing market that helps keep monthly payments relatively affordable even as home prices reach new peaks. In large part because of these low rates, buyers purchasing the median U.S. home as of the end of 2017 should have expected to spend 15.7 percent of their income on a monthly mortgage payment.[1] In the late 1980s and 1990s, mortgage payments took up 21 percent of the typical income, on average. Mortgage rates will need to reach close to 7 percent for the share of income needed to afford the monthly mortgage payments on the nation’s typical home to exceed historic norms.
But rates have also risen almost 50 basis points since the start of the year, and look to finally be at the beginning of a sustained upward trajectory that has been expected for the past several years. In seven large U.S. markets, including four of California’s largest markets[2] and Denver, Portland and Miami, mortgage payments already take up a larger share of income than they did historically. In San Jose, among the nation’s hottest and priciest markets, the share of income needed for mortgage payments increased from 36 percent historically to 46.1 percent at the end of 2017. Combined with record-high home prices, housing affordability is already suffering in these markets and will only worsen as rates climb. And several more areas will join the ranks of historically unaffordable markets as rates climb to 5 percent and on to 6 percent.
If mortgage rates reach 5 percent by the end of this year, and assuming home value appreciation over the course of the year in line with Zillow’s forecast, almost half (17) of the nation’s 35 largest markets will be less affordable than they were historically. If rates reach 6 percent – near the upper end of forecasters’ expectations – homes in 20 of the country’s 35 largest markets will be less affordable than historic norms.
The exact impact of deteriorating affordability on the overall housing market as a result of rising mortgage interest rates is still to be determined. Demand from home buyers is incredibly high right now, driven by a strong economy and an aging millennial population looking to transition from renters to homeowners as they establish careers and start families. The decision to buy a home isn’t based purely on dollars and cents, and it’s likely many home shoppers can absorb somewhat modest increases in mortgage rates and still make their budgetary math pencil out. But sooner or later, the combination of rising mortgage interest rates and rapidly rising home values is likely to push some would-be buyers back to the drawing board.
Additionally, rising mortgage rates may convince some would-be home sellers already locked in at very low mortgage rates to decide not to list their home for sale and get a new mortgage at a higher interest rate. These homeowners, used to a certain monthly mortgage payment, may balk at paying a higher amount per month in financing costs because of rising mortgage rates for a home roughly comparable to their current residence – to say nothing of a home that is more expensive. Instead, they may choose to remodel or otherwise make do. This phenomenon, called “mortgage rate lock-in,” has been expected to materialize for several years. With rates firmly and finally on the rise, it looks set to finally come to fruition.
This could have the effect of reducing already tight inventory levels – and tight inventory, coupled with high demand, is one of the main drivers of currently rapid home value growth to begin with.
Finally, deteriorating affordability and rising mortgage rates aren’t only a problem for would-be home buyers. The roughly one-third of American households that rent are unable to take advantage of very low mortgage interest rates that can serve to mask high monthly housing costs, and face difficult affordability constraints of their own. As of the end of 2017, a renter earning the U.S. median household income and renting the median-priced rental home ($1,439/month) could expect to pay 28.9 percent of their income to their landlord each month – well above historic norms of 25.8 percent. In San Diego, Miami and Los Angeles, renters should expect to spend more than 40 percent of their income renting those areas’ typical apartments each month.
If there is a silver lining for renters, it is that a slowdown in rental appreciation from the highs reached a few years ago, coupled with decent income growth over the past few quarters means renter affordability has improved somewhat over the past couple years. At the end of 2015, a typical U.S. renter could expect to spend 29.3 percent of their income on the median rental nationwide. It’s not much of an improvement, but less income sent to a landlord every month means more potentially saved for a down payment.
Of course, once they have that down payment secured, they will then enter a highly competitive market for a shrinking pool of homes to buy that are slowly but surely getting less affordable as prices and mortgage interest rates rise alongside demand.
[1] We assume the buyer puts 20 percent down; takes out a conforming, 30-year fixed-rate mortgage at rates prevailing at the time of the analysis (3.95 percent at time of analysis); earns the median household income for their metro area (U.S. median was $59,740); and is buying the median-valued home in their market, as determined by the December 2017 Zillow Home Value Index ($206,300 for the U.S. as a whole).
[2] The metros of Los Angeles, San Francisco, San Jose and San Diego
