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Viewpoint: Rising mortgage rates will not derail housing

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The 30-year mortgage rate has risen 0.7% since the election from 3.5% to 4.2% and some are worried that further increases in mortgage rates could derail the housing sector in 2017. That is not going to happen. In our view mortgage rates will climb to 4.5% by the end of this year. If that is the case, housing will remain affordable.

Rising mortgage rates clearly make homes less affordable as monthly payments required to purchase a home rise accordingly. But that is not the only factor that determines housing affordability. Consumer income and home prices both play an important role. If income is rising the potential buyer is better able to afford the higher mortgage rate. Rapidly rising home prices negatively impact affordability.

The National Association of Realtors publishes a monthly index of housing affordability which incorporates all of these factors. In November this index was 166.2. What that means is that potential home buyers have 66.2% more income than is required to purchase a median-priced home. To put this in context, prior to the onset of the recession this index stood at 115.4.

It is easy to replicate this index in an effort to determine housing affordability at the end of this year. It requires estimates of mortgage rates, home prices, and consumer income.

Mortgage rates have risen 0.7% since the election from 3.5% to 4.2%. That eye-catching increase reflects policy changes likely to be implemented this year and their impact on GDP growth, inflation, and interest rates. Trump has indicated he will significantly cut both individual and corporate income tax rates. He wants to reduce dramatically the currently onerous regulatory burden. He wants to allow firms to re-patriate overseas earnings to the U.S. at a favorable 10% tax rate. Those expected changes have already boosted consumer and business confidence. The rise in business confidence is particularly noteworthy since it will entice firms to loosen their purse strings and invest in new technology and refurbish or expand plant capacity. Investment spending has not risen for three years. A pickup in such spending would be a welcome development which should boost GDP growth in 2017 and the years beyond.

Once he takes office Trump will soon discover that implementing such changes will be difficult. Not all Republicans agree on exactly how to accomplish those objectives and Democrats are certain to throw up obstacles. In the end, Republican control of the presidency and both houses of Congress should bring about meaningful policy changes, but probably to a lesser degree than anticipated at the moment. We believe GDP growth will quicken from 2.0% last year to 2.3% in 2017. The core inflation rate will climb from 2.2% in 2016 to 2.7% 2017. The Fed will raise the funds rate three times to 1.25%. These are moderate changes and may disappoint some who were hoping for a more dramatic growth pickup.

In our world mortgage rates will rise from 4.2% today to 4.5% by yearend as the Fed continues to gradually raise short-term interest rates. Such action will boost long-term interest rates but to a lesser degree.

Home prices have risen 4.3% in the past 12 months. Given a moderate pickup in the pace of economic activity and continuing shortage of homes available for sale we anticipate a 5% increase in home prices this year.

Finally, median family income has risen 4.3% in 2016. Given monthly increases in employment of roughly 170,000 per month and faster growth in wages, we anticipate that income will rise 5% in 2017.

If those projections are accurate the housing affordability index will decline from 166.2 currently to 152.0 by the end of this year. Potential home buyers will still have 52% more income than is required to purchase a median-priced home. The reason the index does not fall more quickly given moderate increases in mortgage rates and a gradual increase in home prices, is because consumer income is projected to rise almost as quickly. If the economy gathers some speed job gains should remain solid at 170,000 per month. And given the tightness in the labor market wages are almost certain to grow more quickly in 2017 than they did last year.

As a result, housing will remain affordable in 2017 despite rising mortgage rates. Even at 4.5% mortgage rates are extremely low relative to any other time in history. If we are wrong and mortgage rates rise to 5% the housing affordability would end the year at 142.0 which is still affordable. Look for housing to continue to do well in the year to come.

Reach economist Stephen D. Slifer at steve@numbernomics.com.

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