Monday, December 31, 2012

Why House Prices Will Climb Despite Climbing Interest Rates

Judging from comments here. One of the most difficult concepts to grasp is the relationship between interest rates and housing. The regular question that pops up is, "How can housing prices go up, if interest rates are climbing?"

The short answer is that there is no direct correlation between interest rates and housing prices. Think about it. Since the financial crash in 2007, interest rates have collapsed---but so have housing prices. Here's a chart of 30 year mortgage rates collapsing.


Here's a chart of housing prices (the Case-Shiller Index) for the same period.


Here is complete irrefutable evidence that there is no direct correlation between interest rates and housing prices. What is key is the interest rate relative to price inflation. If the fixed 30 year mortgage rate climbs from its current level of 3.35% to, say, 7%, but the Fed is pumping money in that will cause housing prices to climb by 10%, then it remains profitable for house buyers to buy houses and show a profit. It is only when interest rates are pushed above the current housing price growth that the money flowing into the housing sector starts to slow and eventually push prices lower. But as long as the money is flowing and keeping the Fed keeps the interest rate below the climb in housing prices, the boom will continue.

Here's a chart of 30-year fixed mortgages during the boom period. There was a general uptrend.


Here's what happen to housing prices during that period. Housing prices climbed while interest rates climbed, and actually only slowed the climb, when interest rates started to decline.


Bottom line: There is no direct correlation between housing prices and interest rates. It is very dangerous to look at the absolute interest rate to determine if housing prices are going to go up or down. You need to look at the interest rate on relative terms. As long as the Fed is pumping money to the degree that housing prices will climb higher than a climb in interest rates, the climb in housing prices will continue. Only when rates are pushed higher than the climb in housing prices will housing prices start to slow. Given the amount of money Bernanke is printing, we are nowhere near a period where interest rates will exceed the climb in housing prices. In fact, we are going in the opposite direction, the spread between mortgage rates and the climb in housing prices is expanding.

11 comments:

  1. You are over thinking the problem.

    Point one: We have had 30 years of home price appreciation in less than 10 years. And that was when people had jobs.

    Point 2: The reason home prices are flat is because the masses have no money. Take away the fed and the banks holding onto homes when they should be selling them (market to market no longer exists) and you have a complete reassessment of prices.

    The western economies are contracting. Take away the trillion plus printed/borrowed money and the contraction would be very clear.

    Look at how many people are dropping off the BLS employment numbers. Where are the buyers?

    It's my opinion that the only way for home prices to rise is to have a growing economy with an expanding job base.

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    1. Well said blue skies. You cannot compare what will happen when interest rates rise this time with what happened in the past. Completely different economy.

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  2. Bob, Can you do an anaylsis on housing prices during the 1970/1980s when interest rates started to skyrocket? I'm curious on what the housing prices looked during that time and how our current situation isn't different.

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  3. Also, wouldn't combination of high unemployment and higher interest rates be a factor in housing prices? I'm assuming high interest rates would affect the employment picutre negatively and that would affect the housing prices negatively as well.

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  4. Bob, that is because there is/was still an oversupply of homes. It was a bubble that needed to be popped. Making it easier to borrow money to buy silver contracts in 1981 wouldn't have made the price of silver go higher. Prices eventually find their true market value.

    Prices moved higher as rates moved SLIGHTLY higher in the 2000s because of other factors, mainly zero lending standards fueled by GSEs. To act like interest rates are the only thing moving housing prices is wrong.

    If we were as levered in 1980 as we are now, there is no chance home prices would have been flat to up. Prices would have dropped through the floor. We had savings then, not now.

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  5. More dollars chasing fewer relative goods means higher prices. All the factors you list above may be true, but you can easily come up with other buyers - FED, international investors, speculators, etc.

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  6. You're right that no correlation appears during the 9-10 year span you indicated. However, like Cesar said, I'm curious if a correlation exists over a larger time period (i.e., 1950-2010).

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  7. Are you serious? This is an economics blog and you don’t understand the correlation of home prices to interest rates?

    1. The fact that you chose to use the real estate bubble to make your case is irresponsible and ridiculous. In the early 00s we had a unique situation where as homes were being purchased well beyond the traditional means of the purchaser as the real estate was being viewed as an investment vehicle. So this bubble was completely not chained to income and its irresponsible to suggest that that this can be used as a benchmark.
    2. The crash. Why did we have a crash? Oversupply! Whats the current asset value of the nations REO? We are still in an oversupply in many areas which will continue to depress pricing regardless of interest rates so you are right on that point but that’s irresponsible to make a sweeping conclusion based on a special circumstance don’t you think?
    3. Now that oversupply is being burned off we will return to a traditional ratio of income X payment =price. The fact that the vast majority of Americans determine how much they will spend on housing based on how much it will cost them per month clearly displays that rate DOES have an effect on price.

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    1. The fact that the vast majority of Americans determine how much they will spend on housing based on how much it will cost them per month

      Yes - how much - not if.
      They're still buying.
      The rates had Zero effect.

      Also, oversupply wasn't the cause of the housing crash. Otherwise; houses in areas with an under supply of housing would have maintained their values, everywhere there was an under supply, and that clearly wasn't the case.

      - IndividualAudienceMember

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  8. You've picked two of the most extraordinary periods in housing and its finance and are basing your conclusions on the idea that they are representative of the underlying model. Seems risky to me.

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  9. http://www.investingthesis.com/analysis-insights/correlation-of-mortgage-rates-with-real-housing-prices-how-increasing-inflation-could-affect-housing-prices/

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