Mortgage Rates' Effect on Home Affordability

Interest rates that lenders charge for mortgages and other loans are determined by central banks. Rising rates result in higher borrowing costs, which lowers the affordability of homes. Mortgage rates and home prices both affect affordability. The affordability of homeownership is impacted by changes in either channel, as seen in the chart below. More households will be able to purchase the median new home if mortgage rates decline and household incomes increase at the historical average pace.

Rising rates make borrowing harder for buyers.

The borrowing ability of potential house purchasers declines when mortgage interest rates rise. This is due to the fact that when interest rates rise, so do the monthly payments needed to service a mortgage. Higher rates thus decrease the number of households able to afford the median-priced new home. The subsequent drop in housing affordability has played a role in the new house sales slowdown. Conversely, when mortgage rates decline, potential homeowners' borrowing power rises and they are able to purchase a greater number of properties. Thus, this increases demand and raises the price of real estate. For instance, your client's borrowing ability decreases to $275,000 if they are pre-approved for a $400,000 loan at 4% interest but rates increase to 5.5%. This can severely reduce their possibilities in a market that is competitive. Should this transpire, your client might have to reconsider their spending plan and make concessions about the size of the house they can afford. First-time homeowners may become frustrated by this and decide to postpone their purchase.

Increased home prices make homes less affordable for buyers.

Potential homebuyers may find it challenging to afford the median-priced home in many metro areas, as home prices have increased more quickly than household wages. Furthermore, affordability has been further weakened by the recent sharp increases in mortgage rates and housing prices. Households in the average metro now require an annual salary of $100,000 or more—up from $52,600 three years ago—to be able to pay the mortgage payments on a new property. The good news is that house affordability should increase, provided mortgage rates stay low and property prices rise gradually. However, this might not occur: In fact, the advantages of lower interest rates may be outweighed by rising housing costs and mortgage rates.

Reduced rates make borrowing power greater for buyers.

A number of factors influence the housing market, such as mortgage rates and home prices. An increase in mortgage rates makes it harder to finance a house, and some prospective buyers might decide to rent instead. On the other hand, when mortgage rates decrease, more people may be able to afford to buy a property, increasing the number of potential purchasers. The table below provides an illustration of this by comparing the Housing Allowance Index (HAI) for households eligible to purchase a new home at the median price of 7.25% (the current affordability level) and 6.25 percent (a more normal rate). Mortgage rates can be influenced by a wide range of circumstances, such as the status of the economy, current political developments, and international economic issues. Nonetheless, the Federal Reserve's actions, which aim to promote job creation while reining in inflation, have a significant influence on mortgage rates.

Increased home prices make homes more affordable for buyers.

Many prospective purchasers, especially first-time ones, now find houses out of their price range due to the combination of rising mortgage rates and home prices. Despite the recent cooling off, mortgage rates are not going to go back to their pre-pandemic levels and will likely stay high through the end of 2024. Higher interest rates mean that potential purchasers have less borrowing power and must earn more money in order to be approved for a loan. Their purchasing power is diminished as a result, which raises prices and restricts supply. A decrease in mortgage rates can boost affordability by lowering the required household income to purchase a new home, as the figure below illustrates. As a result, if mortgage rates went back to where they were in mid-February 2022, 4.5 million more households would be able to purchase the new home at the median price. This is the proportion of households that are currently priced out of the market as a result of rising rates and costs. It also suggests that, in order to counteract this trend, additional housing market changes will be required.