Seattle Bubble

Let’s talk about interest rates for a while. As we have discussed before, when most people buy a home, they tend to determine how much they will spend based on the monthly payment they can afford. Two components make up your monthly payment when you buy a home: loan amount and interest rate.

A common theme in recent real estate reporting is to repeat the scare-tactic that rising interest rates will eliminate any savings that “fence-sitters” stand to gain by waiting to buy until prices fall further. It is definitely true that while falling prices drop your monthly payment, rising interest rates cause them to increase. However, if people’s willingness and ability to pay for a home is based entirely on their monthly payment, does it not stand to reason that rising interest rates will actually cause prices to fall even further?

Let’s approach this by way of example. John and Sally Smith have gone to a mortgage broker to get pre-approved. They find that they can afford a monthly payment of $2,700. At an interest rate of 6%, that will be enough to get them a loan for $450,000, the price of a median-priced house in King County (let’s assume they’re also putting zero down).

The Smith’s shop around for a while, but decide to put off purchasing right now. Interest rates go up from 6% to 7%. Now their $2,700 monthly payment can only get them a $405,000 loan. But wait, if everyone is buying homes based on their monthly payment, who is going to buy the $450,000 home? Is it more likely that home prices will be flat/increasing in this scenario, or that prices will drop as interest rates increase?

It may be instructive to look at a visual representation of what I’m talking about here. The blue line on the chart below shows the home price + interest rate combinations that give a monthly principal + interest payment of $2,700. The purple line shows what the monthly payment would be (right axis) for a fixed home price of $450,000.

Click to enlarge

For those who believe that interest rates will climb significantly while home prices stay flat or even increase: I would love for you to explain how anyone will afford homes in that scenario. At even 10% interest, the monthly payment on a $450,000 home shoots up to nearly $4,000.

I’m not saying I don’t think interest rates will go up, I’m saying that rising interest rates will only put even more downward pressure on home prices, in addition to the depreciation that’s already underway. If you have a cohesive argument that demonstrates why things will play out differently, please share.

[Update]
The best argument anyone has brought out so far basically boils down to “prices won’t go down, people will just buy smaller houses.” If that’s the case, won’t sellers of more expensive houses have fewer buyers as a result, forcing them to drop their prices?