When Mortgage Rates Weren't Groovy

March 01, 2018

High interest rates got you down? For the first eight weeks of 2018, mortgage rates have steadily risen, causing potential homebuyers to wonder how high they can go.

If they do continue to rise, as expected, what will be the effects on home buyers, homeowners wishing to refinance, mortgage lenders, home builders, and real estate agents? In our most recent Insight, we look at periods when interest rates spiked and analyze the effects, with the hopes of understanding what might happen in the coming years.

The most dramatic increase in mortgage rates in the last 50 years came during a four-year period ending in 1981, when rates increased from 8% to 18%. This hit the industry hard, causing;

  • New mortgage originations to fall nearly 40%;
  • Annual single-family home sales to drop 36%; and
  • Construction of single-family homes to plummet over 51%.

That's certainly scary, but since 1990, no episode has matched the magnitude of that rate increase. Still, any significant increase in rates are almost always accompanied by reductions in mortgage originations, home sales, and housing starts across the board.

Let's take a look at how this affects borrowers and mortgage lenders, to real estate agents and home builders.

  • Borrowers: The direct effect of increasing mortgage rates is on the borrowers—specifically, their decision as to which home to buy, when to buy, and how much to borrow. For borrowers who already have a mortgage, the decision to refinance is even more sensitive to changes in the mortgage rate than the decision to purchase a home. This is because when rates are increasing, fewer borrowers find that the available terms are today better than their existing mortgage, so refinance activity slows.
  • Mortgage Lenders: Mortgage lenders thrive on the volume of mortgages originated. As mortgage rates increase, borrowers reduce their demand for mortgages, primarily for refinances but also for purchases.
  • Real Estate Agents: Real estate agents contribute to housing markets by facilitating home sales. Rising mortgage rates could have a dampening effect here, but the demand for home purchases will likely remain strong relative to the constrained supply and continue to put upward pressure on home prices.
  • Home Builders: Home builders are doubly affected by increasing rates because they use financing to fund construction costs. When both interest rates on funding for new construction and mortgages rise simultaneously, home builders are squeezed by a fall in demand and an increase in costs.

Based on prior experience, if rates continue to hover between 3.5 and 4.5% and inflation remains low, expect originations, home sales and housing starts to each increase by 5-10% in 2018. But if interest rates push even higher, things get tricky for homebuyers, who will have to decide whether to take the plunge into homeownership despite the increased hit to their wallet, or stay where they are and wait for rates to improve. That could cause originations to drop to as much as 50%, which would obviously have a ripple effect throughout the industry.

For now, even though rates have been rising in recent weeks, they remain historically low compared to the averages over the last four decades.