What Happens When Mortgage Rates Double?

By every measure the housing market is hot! One measure of it is that there are more realtors out there brokering home sales than there are homes to sell. Another measure puts prices 11% higher than they were a year ago. The main driver of all this (besides fleeing apartments in central business districts) has got to be low mortgage rates.

The Fed’s race to zero interest rates in order to shore up the economy has pushed mortgage rates to all time lows buyers are rushing to lock in fixed rates at these levels and existing owners are refinancing. As a result home prices are increasing as too few buyers chase too few homes for sale. This is all fine as long as it keeps up. However, the party can’t last forever.

The Fed has maintained that interest rates will be kept low for the foreseeable future. Not ones to show their hand, the market has interpreted this as a future interest rate hike in 2022. This should keep mortgage rates low and buyers buying. What happens after this? Current rates stand around 3% and with future hikes this rate could easily double in the next 5 years. Will buyers purchase homes at the same rate when rates double?

Say you can afford the median home price of $276,000 in the U.S. with a 3% typical 30yr mortgage. Your payments are $1,100 a month and you spend about 20% of your annual income on that home. Now interest rates doubled. For that $1,100 a month payment you can only get a $210,000 home. Only three quarters the home you once could afford with low rates. Alternatively, if you want that previous house, payments would be $1,500 a month. Most people cannot bend a budget by over a third more without something moving. Either home prices fall or wages increase in this scenario and as we’ve seen in the past, it’s almost always home prices.

Is the Fed thinking about this? They could be. The last time they raised rates they moved at a snails pace. The economy in September 2019 had a tantrum over raising rates and the Fed quickly back down. This time it will likely be even harder. More debt has gotten addicted to low rates and as I just laid out, the housing market cannot sustain a doubling of rates.The Fed may not have a choice. Inflation could show up in meaningful ways forcing their hand and causing rates to rapidly rise. This situation would cause massive panic and most likely another recession!

The Fed has put themselves in this situation we should have never gotten in. We should never have had rates this low where any move of the Fed Funds rate represents a de facto doubling of rates. We will have taper tantrum 2.0 and a potential housing crisis 2.0, at this point it is all but inevitable.