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Tuesday, September 07, 2010

Mortgage Rates and Home Prices

by Calculated Risk on 9/07/2010 10:21:00 PM

David Leonhardt writes at the NY Times Economix: Mortgage Rates and Home Prices

Interest rates are historically low right now. They will surely rise at some point. All else equal, higher rates should push home prices down.
[see graph]
It’s not easy to see much of a relationship.
My best guess for why the two don’t correlate more closely is the role that psychology plays in housing markets. Prices just don’t move as quickly as economic theory suggests they should.

I've tried to explain this several times in several different ways. Price is what you pay for something. Interest rates are related to how the item is financed. Some people pay cash for a house. Would they pay more because interest rates are low? Nope.

Imagine just one buyer gets a special interest rate. Would that lucky buyer be willing to pay more than all other buyers for the same property? Nope.

It is true that low rates make buying more attractive as compared to renting. And that can increase the demand for buying - and more demand might mean slightly higher prices. But if rates are low, a rational buyer will expect mortgages rates to rise when they sell the property, and under the theory that mortgage rates impact price, the price will then fall in the future. That makes the property less attractive, and the buyer in the low interest rate environment will not want to overpay for the house.

So the buyer needs to consider both current interest rates and future interest rates, and by the time they are done doing all the calculations, you get the graph that Leonhardt shows. And that is exactly what I'd expect - there is little relationship between house prices and mortgage rates. That doesn't surprise me at all.

Note: When I wrote about this in 2005, I used a car example. Would people pay more for a car if interests rates are low?