Effects of higher interest rates on housing and consumers

ECONOMY & POLICY

January 19, 2024

Chief Economist Eugenio J. Alemán discusses current economic conditions.

In our Weekly Economics Thoughts of the Week for last week, we showed that the housing market, i.e., real residential investment, had been one of the most impacted sectors by the increase in interest rates over the last several years with real residential investment declining for nine consecutive quarters, quarter-over-quarter, and then slightly recovering during the third quarter of last year, which is the latest available data. At the same time, the sales of homes, both new and existing, have continued to come down as the pool of potential homebuyers continues to shrink due to higher mortgage interest rates on home purchases. However, the increase in what American homeowners must pay on their mortgage, that is, the effects of the effective rate of interest on mortgage debt outstanding has been relatively small, as shown in the graph below, due to the characteristics of the U.S. fixed rate mortgage market.

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Although 30-year fixed mortgage rates have almost doubled since the Federal Reserve (Fed) started its tightening campaign (and more than doubled from their lows in 2020), the effects over the level of the effective rate on mortgage debt outstanding have increased by just 13%. At the same time, we have not seen a buildup in dubious mortgages being sold right and left by unscrupulous mortgage lenders due to the guardrails built after the Great Recession. That has prevented the mortgage industry from relying on the mortgage products that gave rise to the housing market collapse of 2009-2010. Furthermore, the negative impact on Americans’ ability to pay their mortgages has been minimal. Only those who have the income to buy new or existing homes at current prices as well as at current mortgage rates have been buying homes while those who had mortgages before the increase in rates have suffered no increase in mortgage payments over the last two years.

This is very clear by looking at the graph below, where we plot the mortgage debt service ratio, that is, mortgage debt service payments as a percentage of disposable personal income, which has remained at historically low levels and continues to show very little effect of higher mortgage interest rates on American families.

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But not all is rosy for American households

The negative side of the strong increase in mortgage rates has fallen on those who did not have a home before the start of the increase in rates and on the ability of those Americans to purchase a home. Higher mortgage rates have priced many Americans out of the housing and mortgage market, putting further pressure on home rental and lease rates across the country. This is probably one of the reasons why shelter costs have continued to increase and the expected slowdown in those costs has not materialized as economists and analysts were expecting.

Thus, American families that lack a down payment as well as sufficient income to apply for a mortgage at these higher rates and current home prices, are probably the ones paying the largest share of the adjustment due to higher interest rates as home rental rates have continued to move higher. That is, according to the homeownership rate graph below, about 34% of American households today are renters and have been severely affected by the increase in rental rates across the US which comes on top of higher prices for all the other goods consumed by an average consumer. That is, those homeowners with or without mortgages have seen no meaningful increase in housing costs over the last several years while those who are not homeowners have taken a large hit on their purchasing power because of the strong increase in shelter costs.

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GDP Price Index: A measure of inflation in the prices of goods and services produced in the United States. The gross domestic product price index includes the prices of U.S. goods and services exported to other countries. The prices that Americans pay for imports aren't part of this index.

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The FHFA House Price Index (FHFA HPI®) is a comprehensive collection of public, freely available house price indexes that measure changes in single-family home values based on data from all 50 states and over 400 American cities that extend back to the mid-1970s.

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ISM Production Index: The ISM manufacturing index or PMI measures the change in production levels across the U.S. economy from month to month.

ISM Services PMI Index: The Institute of Supply Management (ISM) Non-Manufacturing Purchasing Managers' Index (PMI) (also known as the ISM Services PMI) report on Business, a composite index is calculated as an indicator of the overall economic condition for the non-manufacturing sector.

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The S&P CoreLogic Case-Shiller 20-City Composite Home Price NSA Index seeks to measures the value of residential real estate in 20 major U.S. metropolitan.

Source: FactSet, data as of 7/7/2023