Here in the District of Columbia, where I live, housing prices have become . . . well, I believe that the technical term economists use is “totally insane”. A house (admittedly, an unusually large one) just went for nearly a million dollars in Trinidad, a neighborhood that five years ago was being sealed off by police with roadblocks because of the gang warfare. One block over from us, unrenovated houses with only marginally more space than ours are selling for 50% more than we paid in 2010. People who don’t own homes yet are beginning to despair that they will ever be able to afford anything besides an attractively placed refrigerator box beneath the 14th Street Bridge. People who own homes alternate between gleefully calculating their paper gains, and reminding each other that it can’t possibly last. Those of us with a wonky bent are prone to say things like “When Bernanke finally raises interest rates . . . ”
This often spurs sour talk that Washington is booming thanks to Obama’s massive federal expansion, but we aren’t the only ones having these conversations. Home prices are rising by double-digit percentages across the country. The New York Times is dispensing advice on how to win a bidding war in the brutally competitive local market. Even Las Vegas and Phoenix are having a boom. Pick your explanation for the phenomenon: is it a bubble, or merely the inevitable recovery from the panic of 2009? (As traders like to observe, even a dead cat will bounce if it falls from a great height.) Or is it, as I’ve suggested, the handiwork of Helicopter Ben Bernanke, keeping interest rates low by airdropping oodles of cash into the financial markets?
Interest rates must have something to do with it . . . after all, people generally calculate how much house they can afford by looking at the potential mortgage payment. Say you’re a two-career couple with a combined household income of $175,000 looking at a lovely formstone-covered fixer-upper in DC’s historic Eckington neighborhood, close to all major amenities such as the Big Bear Cafe, the NoMa metro stop, and the Exxon Mobil station at Florida and North Capitol Avenue. The house is listed at $540,000. What will you actually be willing to pay?
Assuming that this couple has no children and are sensibly putting at least 10% of their annual income into their 401(k), they should be bringing home about $9750 every month. They probably have a student loan or two, and because we said they’re sensible, they don’t want more than a third of their income to go to housing costs. That means a monthly mortgage payment of no more than $2850 a month, to leave room for insurance and property taxes. (Property taxes in the District are thankfully very low).
How much they can bid for the house? Let’s say they’re able to put $50,000 down. At current interest rates, with 30-year mortgages on offer for an APR of about 3.75%, Bankrate tells me that they can afford a mortgage of about $615,000. This means that they are able to offer as much as $665,000 for this historic Eckington gem. They are not going to offer that much, we hope, because that house isn’t worth it, but they could if they wanted to.
However, what if interest rates go up to 4.75%? Still near historic lows, but considerably more expensive than what recent buyers have paid. Then our hypothetical couple could only afford a mortgage of about $550,000, for a total offer of $600,000. The current owner of this formstone-clad palace will probably be getting a smaller check.
As you can see, in our thought experiment higher interest rates take a big chunk out of housing prices. So it stands to reason that when Ben Bernanke finally turns off the tap, the housing market should soften. Hell, mortgage rates are rising now; maybe we’re already hovering on the edge of a correction.
But not so fast! An article in yesterday’s LA Times argues that in the short term, rising interest rates may actually increase demand for housing, which would drive prices even higher. There are two reasons for this. First, as interest rates rise, refinancings fall off, so mortgage lenders have more incentive to offer attractive rates to people making home purchases. And second, people who have been maybe thinking about buying a house may decide to leap in before rates go up any further. More buyers in a tight market means higher prices.