“The NAR (National Association of Realtors) forecasts the 30 year fixed mortgage rate
to hit 3.7% at the end of 2022, a borrowing rate that the industry group’s economists
believe is still low enough to keep the housing boom going.”
- Nicole Friedman, Orla McCaffrey and Sam Goldfarb,
“Mortgage Rates Hit Highest Level Since ‘20", Wall Street Journal, January 7, 2022.
In my last blog post, I focused on the sheer volume of added housing needed over the current decade — particularly focused on the large cohorts of aging baby boomers and family-forming millennials. This post posits another dimension of the housing challenge — related to the prospect of increasing interest rates in a period of increasingly challenged housing affordability. Then we broaden the discussion, to consider winners and losers currently and with a potential return toward a more normalized interest rate environment.
From a low of 2.65% in early January 2021, mortgage rates averaged 3.45% for the week ending January 13, 2022 (as reported by the January 13 Wall Street Journal based on Freddie Mac data). For the median wage mortgage borrower, this means a loss of over $50,000 in housing purchasing power — a drop of nearly 10% in one year.
The Math of Mortgage Rates & Affordability
It’s worth beginning with a quick review of the mathematical relationship between housing affordability and mortgage interest rates. Here’s what it might look like for a typical American household with a median income of $72,200 for 2022 (as estimated by the national data firm Claritas). Also assume a mortgage loan at 80% of home purchase price, a repayment term of 30 years and mortgage payment at about 28% of household income.
The following graph illustrates the amount of an affordable mortgage and total home price at varying interest rates for our typical household. An interest rate in the +/-3% range represents the rates available over much of the last couple of years — the lowest recorded dating back to at least the early 1960s. A 10%+ interest rate was the mortgage yield environment when Ronald Reagan assumed the presidency in 1981 from Jimmy Carter — which then peaked in the 16-17% range the first two years of Reagan’s inaugural term.
At an interest rate of 16%, this household earning $72,200 per year (in todays’ dollars) could only afford a house with a purchase price of about $157,000. In our recent interest rate environment, affordability more than triples to a supportable value of just under $500,000 (at a 3% interest rate).
Interestingly enough, according to data of the Federal Reserve Bank, the median price of a home sold in 1981 was $68,950. As of the 3rd quarter of 2021, median home price was at almost $385,700. In effect, today’s lower interest rates explain just over half of the appreciation in housing values since 1981. The remainder of the increase in home valuation can be attributed to inflation and an increased standard of American living.
This economic engine goes into reverse in an economic environment where interest rates increase rather than decline. As illustrated by the foregoing graph, our typical household’s purchasing power is reduced by over 12% if mortgage interest rates go up from, say 3% to 4%. If rates increase by 4% to 5%, home purchasing power is reduced by another 11% for a combined 23% reduction in housing affordability.
A not so pleasant feature of increasing rates — especially from a starting point of historically low rates — is that the dollar hit to housing purchase capacity is greater at the initial jumps in rates than as rates move higher. The loss of purchasing power is greater going from 3% to 4% than from 4% to 5% — and so on.
Heading Toward Normalized Rates?
If the U.S. is at abnormally low rates of borrowing cost, one might ask: Is there such a thing as a normalized interest rate? And if so, what is it?
There is no perfect answer to this question. And certainly no answer around which consensus is readily apparent.
One approach to this question is to consider the pattern of relatively risk-free Treasury rates as compared with mortgage yields over a time period for which data is readily available. The time period for which both 10-year Treasury and 30-year mortgage rates as well as consumer price index (CPI) data are available in reasonably consistent manner extends back to 1963-64, as illustrated by the following graphic.
Note: CPI data is from the U.S. Bureau of Labor Statistic (BLS). The Federal Reserve Bank and U.S. Council of Economic Advisors (CEA) provide 10-year Treasury rates starting in 1953 (30-year Treasury rates are provided starting in 1977). The most recent Economic Report of the President (issued by CEA) provides home mortgage yields starting in 1971, defined as contract interest rate on commitments for 30-year. first-lien prime conventional conforming home purchase mortgage with a loan-to-value of 80 percent. A prior CEA report provides mortgage rates extending back further to 1963. Although the earlier data is not fully comparable to that of more recent reports, a composite of the two data sets is used to cover the longer historical time period as depicted above.
From 1964-2021, 10-year Treasury interest rates have averaged about 2.16% points above the CPI. This is in-line with what many economists historically have accepted as a 2% point spread between Treasury rates minus inflation. In other words, in an inflation-free world, the inflation-neutral Treasury rate would be about 2%. But with this discussion, the focus is primarily on the relationship between mortgage rates and their relationship both to Treasury rates and inflation.
From 1964-2021, mortgage rates have averaged 7.68%. By comparison, the 10-year Treasury rate has averaged 6.02% — about 1.66% points below the average mortgage yield. Over this full time period, mortgage rates have varied widely, from a peak of between 16-17% in 1981-82, reduced to less than 3% averaged across the 2021 calendar year just completed.
The spread between 10-year Treasuries and mortgage rates has ranged within a relatively tight band, from a difference of just over one percentage point in 1975 albeit to a much wider spread of about 3% points in the hyperinflation period of 1981-82.
But let’s come back to the seemingly more variable relationship between inflation and interest rates — a time series that may fluctuate year-by-year, obscuring the underlying average 2% spread. Generally speaking, interest rates tend to rise and fall somewhat in synch with inflation, but timing is not always in synch. The interest rate run-up of the early 1980s was preceded by inflation spikes — initially with the oil embargo in 1974 and then again from 1979-81 (with 1981 coincidentally being the peak year for mortgage interest rates).
Through active efforts of the Federal Reserve, inflation was choked off by 1983 but with interest rates much slower to drop. Over the 67-year run of this comparative data series, mortgage rates have averaged nearly four percentage points above the CPI. When inflation equals or exceeds mortgage interest rates (as in the late 70s and early 80s), interest rates eventually take off. With inflation now at an annual pace exceeding 7% this past year and well above current mortgage interest, is there any doubt as to whether interest rates are about to take off again? The question is not whether mortgage rates escalate, but rather: when and by how much?
Winners & Losers
If historical experience is any guide, there is little doubt but that mortgage interest rates have recently hovered at unsustainably low levels. Whether from the perspective of practical economics or public policy, there is no inherent rationale as to why home purchasers should benefit unduly from perpetually low rates — especially when the cost of living is now running ahead of the cost of borrowing.
To this point, we have focused on the home mortgage market. But now broaden the perspective to consider the wider range of winners versus losers in the recent environment of historically low interest rates.
Winners:
Home purchasers (especially those with good credit and/or trading up)
Corporate borrowers (with good credit, strong market share and/or high growth)
Essentially all equity investors with leverage capacity (whether with real estate, stocks/bonds, commodities, maybe even cryptocurrency)
Public agency borrowers (with added municipal or enterprise debt and capacity for debt coverage)
U.S. taxpayers (in the form of lower interest payments on the national debt)
Losers:
Individual savers (especially those who are lower income, elderly and/or otherwise more risk averse seeking a comparatively safe but yet financially worthwhile return)
Those just seeking to enter the market (but priced out, as for first-time home buyers)
Long-standing but low growth businesses (reliant on cash flow and/or with healthy balance sheets)
Lenders (seeking higher returns but at often of increasingly greater risk as in 2007-09)
In effect, the current situation of low interest rates and rising inflation benefits investors (risking capital in search of higher return) at the expense of savers (with less tolerance or capacity for risk). This also appears to be an environment that has been favoring rapid technological innovation at the expense of greater economic and social churn.
An unduly high interest rate environment leads to public and private capital underinvestment. Conversely, a low interest world may yield overinvestment for marginal return and stranded capital (accompanied by more rapid functional or economic obsolescence of existing assets).
Recognizing that the balance has shifted substantially in recent years toward investors, there is a clear case to move toward normalization where interest rates rise to exceed inflation, providing more balanced and remunerative opportunities to savers. However, the risk going forward is that even apparently small increases in interest rates from the current low base can have an outsize negative impact on borrowing capacity.
A return to the high rate environment of the Carter/Reagan era is the last thing that monetary and fiscal policy should aim to achieve. Rather, look for slow incremental steps so that the market (of both investors and savers) have time to adjust. Don’t burst the balloon; just let the air out slowly — reaching toward a more balanced approach consistent with historic precedent.
For the mortgage market, increase rates slowly but surely — allowing for residential pricing to also re-adjust gradually without extreme whiplash for either purchasers or sellers.
