Higher mortgage rates rein in buying power

With mortgage rates increasing at a slow but steady pace this year, several real estate organizations say buyers entering the market are likely to encounter diminished purchasing power.

While continued growth in median home prices in recent years has presented an affordability challenge for buyers and increased competition for listings with lower asking prices, mortgage rates have generally stayed at historic lows. According to Freddie Mac, the average rate for a 30-year fixed rate mortgage held around 3.5 percent for much of 2016 and between 3.8 percent and 4 percent for the majority of 2017.

In 2018, the average rate has climbed from 3.95 percent on Jan. 4 to 4.86 percent on Oct. 25. This is the highest weekly average rate since April 14, 2011.

"We expect rates to continue to rise, which will put downward pressure on homebuying activity," said Sam Khater, chief economist at Freddie Mac. "While higher borrowing costs will keep some people out of the market, buyers with more flexibility could take advantage of the decreased competition."

Surveys by the real estate brokerage Redfin have found that few prospective homebuyers would be deterred by mortgage rates hitting 5 percent. However, recent research from the company suggests that buyers with a specific budget in mind should also be prepared to set a lower cap on a home price they can afford.

Redfin determined that a buyer looking to limit their monthly mortgage payment to $1,500 a month could typically afford to pay up to $284,250 for a home with a mortgage rate of 4 percent. The maximum affordable home price drops to $260,750 with a mortgage rate of 5 percent and $239,750 with a mortgage rate of 6 percent.

The drop in affordability was more pronounced with higher monthly budgets. A buyer looking to pay $3,500 a month on their mortgage could afford to spend up to $663,250 with a mortgage rate of 4 percent, $608,500 with a mortgage rate of 5 percent, and $559,500 with a mortgage rate of 6 percent.

This analysis found that higher mortgage rates can considerably reduce the number of affordable properties. For example, the number of three bedroom, two bathroom homes affordable on a $3,500 monthly payment dropped by 39 percent in San Jose, Calif. with a rate increase from 4 percent to 5 percent.

"Every fall and winter we see prices decline relative to spring and summer, but this year's seasonal declines have been more extreme as buyers, especially in coastal markets, are finally reaching a limit in terms of how much they are willing to pay," said Daryl Fairweather, chief economist at Redfin. "Sellers haven't quite come to terms with the fact that they no longer have buyers wrapped around their finger. This push and pull is likely to continue until early 2019 when the homebuying season picks back up."

Mortgage rates have led to a considerable increase in mortgage payments, according to the housing data company CoreLogic. Andrew LePage, writing for the CoreLogic Insights Blog, said the typical mortgage payment in July was up 13.1 percent compared to July 2017. The year-over-year home sales price rose 5.8 percent to $230,411 in the same period.

The real estate site Zillow came to a similar conclusion. Aaron Terrazas, writing for Zillow Research, said the typical mortgage payment in August increased by $118—15.4 percent—from the previous year, compared to a year-over-year increase of 6.5 percent in home values.

However, Terrazas says homeownership continues to be more affordable than usual, and considerably more affordable than renting. The typical household spends 17.5 percent of its income on a mortgage, below the historic norm of 21.2 percent. Renters typically pay 28.4 percent of their income, or 36.8 percent in urban areas; the historic norm is 25.8 percent.

First American Financial Corporation, which provides several services for real estate transactions, says in its most recent Real House Price Index that average mortgage rates will likely reach 5 percent in 2019. The report concludes that if rates were to increase to this level, a potential buyer with a $64,000 household income and 5 percent down payment would see their buying power drop 5.5 percent, from $366,000 to $346,00. This would also be 11 percent lower than their buying power in July 2017, when the average mortgage rate was 3.97 percent.

This company said buyers are still experiencing stronger buying power than usual, since average household incomes are 53 percent higher than in January 2000 and rates remain close to historic lows. The report concluded that the typical consumer's buying power is 2.2 times higher today than it was in January 2018.

"Changes in affordability depend on the tug-of-war between rising household income and inflation-driven pressure on mortgage rates," said Mark Fleming, chief economist at First American.

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