How Mortgage Rates Impact Home Prices

If you have walked through the aisles of your local grocery store or stopped at the gas station lately, you have seen the impact of the increased rate of inflation that the United States is facing. Most economists agree that the increase in interest rates is due to the economic chaos that was started by the COVID-19 pandemic. Even though we seem to be coming out of the “pandemic era,” the economic impacts of the global pandemic are expected to be felt for quite some time.

As is always the case, an increase in inflation rates has had a direct impact on the mortgage industry. When the mortgage industry is impacted, the asking price for homes reflects it. When inflation rates go up, so do mortgage rates. Whether you are buying or selling a home in today’s real estate market, it’s important that you understand how those rates impact home prices.

How Do Mortgages Work?

Before we fully dive into how mortgage rates impact home prices, we should gain a solid understanding of how mortgages work. In most cases, people who buy homes obtain a mortgage because they don’t have enough cash on hand to make a full-cash offer for a home. The borrower and the lender come to an agreement about how much money will be borrowed, and the borrower will make monthly payments in order to pay the money back over time.

In order to stay in business, those lenders must charge interest on the money that they lend. In addition to ensuring that they make a profit on the money that they lend, lenders must charge interest to protect themselves from the risk of a borrower defaulting on the loan.

Interest rates are determined by the central bank, which means the economy plays a significant role in the amount of interest that a borrower must pay on a mortgage. Higher interest rates lead to higher monthly mortgage payments. Since the purchasing power of a dollar decreases when inflation rates go up, lenders must charge higher interest rates on the money that they lend.

What Happens When Mortgage Rates Increase?

Before we dive into the impact of mortgage rates on home prices, let’s take a look at what happens when mortgage rates go up. If a buyer wants to purchase a home that costs $400,000 and mortgage rates are at 4%, a borrower will need to pay around $1,900 per month for the duration of a typical 40-year mortgage. If the same buyer finds the same home while mortgage rates are at 5%, their monthly payment would be $2,138 per month.

An increase of $238 over the life of a 30-year mortgage results in the borrower repaying $85,680 more. Obviously, an increase of that magnitude results in fewer people being able to obtain mortgages. Generally, higher mortgage rates lead to fewer people actively looking for homes to purchase.

At the end of 2021, mortgage rates were around 3%, which is quite low. However, by April of 2022, those rates had jumped to around 5.1%. This means that the monthly payment on a $300,000 home had increased from $1,283 in 2021 to $1,629 by April of 2022, an increase of 27%.

The Laws of Supply and Demand

Whether you’re buying or selling a home, there are few factors that matter more than pricing. Obviously, location has always been (and will always be) the most important aspect of real estate, but pricing is a very close second. When trying to sell your home, it is crucial that you price your home competitively. However, you also want to make sure that you get as much money as possible out of your home.

On the other side of the transaction, home prices are a major part of the puzzle for buyers. When shopping for a home, you likely do so on a budget. Your mortgage lender will let you know how much you can afford to spend on a home, so you need to find homes that fit within your budget.

The entire real estate industry largely hinges on the laws of supply and demand. When there are more buyers than sellers in a market, sellers are able to charge more for their properties, as the inventory is lower. Conversely, when there is a lot of inventory but very few buyers, sellers will need to lower their asking price in order to sell their home. When a single buyer has his or her choice of homes, the buyer holds most of the leverage in negotiations.

What Mortgage Rates Mean for Home Prices

Higher mortgage rates decrease the number of viable buyers in the housing market. Not only does it become harder for people to get approved for loans, but qualified buyers often choose to wait for mortgage rates to return to normal before they obtain a mortgage. If those buyers are not in a position where they must make a move, it’s not uncommon for them to wait for lower mortgage rates before making a purchase.

Fewer buyers in the market means that home sellers need to lower the asking price of their homes. Obviously, this is great news if you are a buyer who has already started the pre-approval process. You can expect home prices to be lower because you don’t have as much competition. Not having to fear a bidding war gives you a great advantage when you begin the negotiation process. Unfortunately, if you are trying to sell your home in today’s market, you should plan on it taking longer, and you will need to be open to negotiating on your price, as there simply aren’t as many qualified buyers in the market.

Are Mortgage Rates Expected to Drop?

At the onset of the pandemic, policymakers in Washington D.C. lowered interest rates to historic lows. In fact, there was a time in 2020 when mortgage rates were below 2%, the lowest they had ever been. Economists do not expect interest rates to ever return to those levels. Those rates were reflective of an unprecedented event that left the Federal Reserve scrambling to stabilize the economy.

However, it is also expected that interest rates will not return to the 5.1% levels that they were at earlier in 2022. Instead, economists believe that interest rates will stabilize at somewhere between 3.5% and 4% by the end of 2022.

Ideally, this will lead to a stabilization of the real estate market. Since interest rates will not be too high or too low, home prices should return to a more normal level.

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