How Important Are Mortgage Rates?

There is growing talk that mortgage rates (home loans) will not only break above 7% but settle into the 8% range. The current 30-year mortgage rate is in the low 7% range, the highest level in the past decade and holding there. It is natural to think, “With rates this high, isn’t it a given that home prices will fall?” But reality is more complicated than that. For the housing market to truly break, interest rates alone are not enough.

The two key words are income and supply. Let’s look at income first.

From 2021 to early 2023, inflation (black line) rose faster than the income growth rate (blue line). In other words, people’s real incomes were shrinking (income growth minus inflation). Recently, however, inflation has shown signs of easing somewhat, and real incomes have started to rise again.

Home prices are a function of many variables (no one knows exactly what that function is, and even if we were to find a function that fits the current moment, it would lose accuracy the moment it is discovered. Jane Street is not stupid; there is a reason they pay top dollar to recruit math and statistics majors from elite universities. So it is astonishing to see a certain Korean startup claim that AI can generate alpha endlessly—they must have worked a miracle.), but historically the variable that seems most important is income.

Income is ultimately what allows people to pay rent or make mortgage payments. Whether you rent or own, it is common to allocate about one-third of your income to housing (or at least that level is generally considered appropriate), so it is reasonable to assume that income is the single biggest variable. And although the growth rate of income has slowed, the fact that it is still increasing on a sustained basis suggests that, in terms of what we usually call the “fundamentals” of the housing market, there is no major problem.

Turning to supply, the only way to describe the situation is that it is woefully inadequate.

The root cause of the supply shortage lies in the U.S. housing bubble that lasted until 2007 and its subsequent collapse. As the housing market overheated, homes that no one was actually going to live in kept being built, and even people with no income were taking on debt to buy houses.

When interest rates rose, that bubble burst within two years, and the housing market cooled rapidly. The problem is that as the housing market froze, many homebuilders went bankrupt, leaving too few firms capable of building houses.

The chart shows that housing supply steadily improved through 2022, but the National Association of Home Builders still estimates that the U.S. is short several million homes. The segment where supply is most lacking relative to demand is single-family homes.

With income (the demand lever) and supply (the supply lever) creating a favorable backdrop for rising home prices—essentially, with the kindling in place—the spark that lit the fire was the combination of ultra-low interest rates, quantitative easing, and a government-led wave of cash-based welfare programs.

Looking at the chart above, the median transaction price of U.S. homes, which was around $320,000 before COVID, surged to $480,000 at the peak—an increase of nearly 60% in just two years. The policy rate, which has risen by more than 5 percentage points, managed to pull this down to about $420,000 within a year (a decline of more than 12%), but prices still remain far above pre-COVID levels.

The big question, of course, is what happens next. To jump to the conclusion, soaring interest rates make another sharp run-up in prices unlikely, but any decline is also expected to be limited.

First we need to understand the structure of the U.S. housing market. Traditionally, the "standard" has been to put 20% down and finance the remaining 80% with a 30-year mortgage. But as more buyers have accumulated cash, they have been making larger down payments, so homeowners’ equity has actually continued to rise.

For example, in the past you might have effectively paid for just the bathroom with your own money and bought the rest of the house with the bank’s money. These days, you are paying for at least the living room with your own funds and using the bank’s money for the remainder.

Another factor supporting this downside rigidity is that, after the 2008 financial crisis, banks significantly tightened their lending standards. Most homeowners today are high-credit-score, high-income borrowers, and the main scenario in which they would be forced to sell is if they suddenly lose their jobs. If a very large number of such homeowners were to lose their jobs at once, a wave of selling could hit the market and push home prices down.

However, for now, the likelihood of a mass layoff event on the scale of 2008–2009 does not appear to be particularly high.