For example, consider a $300,000 mortgage. At a 4% interest rate, the monthly principal and interest payment would be approximately $1,432. If the rate increases to 6%, that same payment jumps to $1,799, a difference of $367 per month or $4,404 per year. This significant increase in the cost of homeownership can price many potential buyers out of the market, especially first-time homebuyers who may be stretching their budgets to begin with.

The National Association of Realtors (NAR) uses a Housing Affordability Index that takes into account median home prices, median family income, and prevailing mortgage rates. When interest rates rise, this index typically falls, indicating decreased affordability. In 2023, we saw this play out dramatically as mortgage rates reached their highest levels in over two decades, causing a significant slowdown in home sales.

However, the relationship between interest rates and demand is not always linear. In some cases, the anticipation of rising rates can actually spur demand in the short term, as buyers rush to lock in rates before they increase further. This “fear of missing out” can create temporary spikes in market activity.

The Supply Side: A More Complex Picture

While the effect of interest rates on demand is relatively straightforward, their impact on housing supply is more nuanced and often overlooked. Interest rates influence supply through several mechanisms:

1. New Construction: Higher interest rates increase the cost of financing for developers and builders. This can make some projects financially unfeasible, leading to a reduction in new housing starts. The National Association of Home Builders (NAHB) regularly reports on builder sentiment, which often declines as interest rates rise, reflecting decreased willingness to take on new projects.
2. The “Lock-in” Effect: As interest rates rise, existing homeowners who have mortgages at lower rates become reluctant to sell and take on new, higher-rate mortgages. This phenomenon, known as the “lock-in” effect, can significantly constrain the supply of existing homes on the market. In 2023, with average 30-year mortgage rates hovering around 6.6%, many homeowners who secured rates below 4% during the pandemic era were effectively “locked in” to their current homes.
3. Renovation vs. Relocation: Higher rates can also influence homeowners’ decisions to renovate their current homes rather than move to new ones. This can further reduce the supply of existing homes on the market while simultaneously increasing demand for home improvement loans and services
4. Investor Behavior: Real estate investors, particularly those focused on rental properties, may find their calculations changed by higher interest rates. If the cost of financing exceeds potential rental income, investors may choose to sell properties or refrain from new purchases, affecting both supply and demand in various segments of the market.
   
   

The Counterintuitive Impact on Home Prices

Conventional wisdom might suggest that higher interest rates would lead to lower home prices as demand decreases. However, the reality is often more complex. The “lock-in” effect mentioned earlier can actually contribute to price stability or even increases in some markets. As the supply of available homes constricts due to current homeowners’ reluctance to sell, the reduced inventory can create upward pressure on prices, even in the face of reduced demand from new buyers.

This phenomenon was observed in many markets throughout 2023. Despite significantly higher mortgage rates compared to the previous year, home prices in many areas remained stubbornly high or even continued to appreciate, albeit at a slower rate than during the pandemic-era boom.

Long-Term vs. Short-Term Effects

It’s important to distinguish between the short-term and long-term effects of interest rate changes on the housing market. In the short term, rate increases can cause market disruptions, leading to a slowdown in transactions and potential price volatility. However, over the long term, the market tends to adjust to new interest rate environments.

Historically, the housing market has shown resilience to various interest rate regimes. In the 1980s, for instance, when mortgage rates soared to 18% or higher, people still bought homes, albeit with different financing structures and expectations. The key factor is often the relative affordability of housing compared to renting and overall economic conditions, rather than absolute interest rate levels.

The Role of Government and Monetary Policy

The Federal Reserve’s monetary policy decisions have far-reaching implications for the housing market. While the Fed doesn’t directly set mortgage rates, its decisions on the federal funds rate influence the broader interest rate environment. In recent years, we’ve seen how the Fed’s efforts to combat inflation through rate hikes have rapidly translated into higher mortgage rates, cooling the housing market.

Government policies can also play a significant role in mitigating the effects of interest rate changes on housing supply and demand. For example:

• First-time homebuyer programs can help offset the impact of higher rates for new entrants to the market.
• Zoning reforms and incentives for developers can help increase housing supply, even in higher-rate environments.
• Tax policies, such as the mortgage interest deduction, can influence the relative attractiveness of homeownership versus renting.
  
  

Looking Ahead: Navigating Uncertainty

As we move through 2024 and beyond, the housing market faces a period of uncertainty. The potential for interest rate cuts, as hinted at by Federal Reserve projections, could reignite demand and potentially unleash pent-up supply as homeowners feel more comfortable with the idea of selling and buying in a lower-rate environment.

However, the timing and magnitude of any rate changes remain uncertain, and the market will need to contend with other factors such as overall economic conditions, demographic shifts, and potential policy changes.

For real estate professionals and investors, staying attuned to these dynamics will be crucial. Strategies that worked in the low-rate environment of the early 2020s may need to be adjusted for a world of higher (or more volatile) interest rates. This might include:

• Focusing on markets with strong fundamental demand drivers beyond just interest rates, such as job growth and population increases.
• Considering alternative financing structures that can make homeownership more accessible in higher-rate environments.
• Exploring opportunities in the renovation and home improvement sector, which may benefit from homeowners choosing to upgrade rather than move.
  
  

Conclusion

The effect of interest rates on housing supply and demand is a complex interplay of economic forces, human behavior, and policy decisions. While higher rates generally dampen demand and can constrain supply, the specifics can vary greatly depending on local market conditions, overall economic health, and the rate of change in the interest rate environment.

As we navigate through this period of adjustment in the housing market, it’s clear that a nuanced understanding of these dynamics is essential. The market has shown remarkable resilience and adaptability over time, and those who can anticipate and adjust to changing conditions will be best positioned to succeed, regardless of where interest rates may head in the future.