How High will Mortgage Rates Rise?

What is the impact of rate increases on affordability?

A few mortgage rate topics:

1. What are current rates?

2. How high will mortgage rates rise?

3. How do higher mortgage rates impact affordability?

What are current rates?

Mortgagenewsdaily.com reports current 30-year fixed mortgage rates are at 5.12% for top tier scenarios. The Mortgage Bankers Association’s (MBA) reported this morning that as of April 8th:

The average contract interest rate for 30-year fixed-rate mortgages with conforming loan balances ($647,200 or less) increased to 5.13 percent from 4.90 percent, with points increasing to 0.63 from 0.53 (including the origination fee) for 80 percent loan-to-value ratio (LTV) loans.

And Freddie Mac reported last week:

Freddie Mac … released the results of its Primary Mortgage Market Survey® (PMMS®), showing that the 30-year fixed-rate mortgage (FRM) averaged 4.72 percent.

“Mortgage rates have increased 1.5 percentage points over the last three months alone, the fastest three-month rise since May of 1994,” said Sam Khater, Freddie Mac’s Chief Economist. “The increase in mortgage rates has softened purchase activity such that the monthly payment for those looking to buy a home has risen by at least 20 percent from a year ago.”

All of these measures move together over time (and the Freddie Mac PMMS is used for historical data), however when rates are moving quickly, mortgagenewdaily.com is the most up to date.

How high will mortgage rates rise?

First, mortgage rates are high compared to predicted levels based on 10-year treasury yields.

Freddie Mac has a graph here with a linear fit (using data since 1990).   Using their formula, with the 10-year treasury yield at 2.7%, 30-year mortgage rates would usually be around 4.5%. However, we can see from the graph that there are periods when the 30-year is above the trend line.

Here is a similar graph showing the relationship between the monthly 10-year Treasury Yield and 30-year mortgage rates from the Freddie Mac survey since 1971. The large red marker is the current Freddie Mac PMMS rate. Using this formula, mortgage rates should be around 4.5%, but this is still within the normal variability - and it seems likely investors in mortgage-backed securities are factoring in future increases in interest rates.

Currently most forecasts are for the Fed Funds rate to rise to around 3.25%. Goldman Sach’s chief economist Jan Hatzius recently said he thinks the Fed may have to raise rates above 4%, although their baseline forecast is just about 3%.

When the Fed Funds rate peaks in this cycle, the yield curve will likely be fairly flat - meaning the 10-year treasury yield will be at about the same level as the Fed Funds rate. Based on the current estimate for the peak Fed Funds rate (3.25% to 4.0%), the 30-year fixed mortgage will likely peak at between 5.0% and 5.7%. There is some variability in the relationship, so we might see rates as high as the low 6% range. (This all depends on inflation and the Fed Funds rate - but I don’t expect rates to move much higher than the current rate - although 6% is possible).

Of course, rates are still historically low. But rates are up sharply from the recent lows, and my view is the change in rates is what will impact housing (see my post last month: Housing, the Fed, Interest Rates and Inflation; Housing is a key transmission mechanism for the FOMC). Here is a long-term graph of 30-year mortgage rates (Freddie Mac PMMS, March is today’s rate).

How do higher mortgage rates impact affordability?

Higher rates will impact affordability. Based on today’s mortgage rates, affordability has declined to levels not seen since the housing bust).

However, it is important to understand that if mortgage rates double - say from 2.5% to 5.0%, monthly payments do not double. For this example, principal and interest payments would increase about 35%, and if you include taxes and insurance (PITI), payments will increase about 25%. This is a huge increase, but payments do not double when mortgage rates double.

Assume a family had $100 thousand for a down payment and could afford $2,000 per month in PITI. They could afford a $485,000 house with a 2.5% mortgage rate.

Using the same assumptions, with a 5.0% mortgage rate, this family could afford a $400,000 house - about 17% less.

This increase in mortgage rates will decrease the pool of buyers at each price point and will likely slow house price increases.

I’ll have much more on the impact of higher mortgage rates on house prices, inventory, new home sales and housing starts.

In summary:

1. Current 30-year mortgage rates are around 5.1%

2. Mortgage rates are probably close to the peak for this cycle (depending on inflation) but might rise to the low 6% range if the Fed has to raise rates to 4%.