Home prices are running wild—what’s next?

Even with mortgage interest rates surging, U.S. housing markets continue to run hot.

• Mortgage interest rates are climbing after a period of historic lows that fueled a homebuying spree.

• Home prices are high and getting higher. There’s a logical explanation beyond just mortgage rates.

• It’s not a housing bubble, and a widespread drop in home prices is unlikely in the near term.

What’s going on with mortgage interest rates?

Mortgage rates are on the rise again after a two-year period of historic lows. The interest rate for a typical home loan topped 5%, marking the most rapid increase in 35 years.

The green line in the chart below shows the interest rate on a typical mortgage:

This rate matters because it determines the cost of buying a home. Since a house is typically the biggest purchase in anyone’s life, most buyers arrange for a mortgage loan from a bank.

Banks agree to give these loans because people pay them back over time with interest. And homebuyers benefit because they get to buy a house without having to pay the full value upfront. Instead, borrowers make smaller payments over time along with some interest.

Interest ends up being the price of the loan. The lower the rate, the less payments will be. Lower rates make mortgages more affordable, which can sometimes fuel demand for homes and drive housing prices higher.

Low mortgage rates from 2019 to 2022 were a primary cause of the steeper trajectory of home prices during that time, as shown by the blue line in the chart above.

But now interest rates are rising, which increases the cost of mortgages. Monthly payments for the typical loan on an average home have increased by over one-third, from around $1,250 to upwards of $1,700.

People might expect such an increase to have the effect of discouraging demand and lowering prices. But demand has actually remained strong, and home prices continue to climb.

Home prices are high and getting higher. It’s about more than just mortgage rates.

So interest rates are up but home prices continue to climb higher. What’s driving this? Look no further than some good old-fashioned supply and demand.

In simple terms, prices are rising because demand from homebuyers is outpacing the supply of homes for sale.

On the supply side, the inventory of existing homes is as low as it’s ever been (since it started getting measured back in 1999).

Some baby boomers are choosing to retire later and put off downsizing due to the pandemic. Other homeowners locked in refinanced interest rates at lower levels, and others are simply reluctant to sell because it means they have to find somewhere else to live right now. Also, new home building has become slower and more expensive due global supply chain issues.

For demand, historically low interest rates certainly helped boost the buying spree of the past few years. And even with the recent surge in rates, mortgages are remarkably affordable by historical standards.

But other factors are at play as well. Buyers are seeking more space due to the pandemic, and remote work has made it easier than ever to live in residential areas further from urban office space.

Household finances have also improved, as people accumulated a tremendous amount of savings recently. Research suggests over $2.5 trillion in excess savings were amassed since the start of the pandemic. Padded savings make mortgages more accessible for many more Americans.

Demographics play a key role too, as the millennial generation now accounts for more than half of all new mortgages taken out each year.

Millennials surpassed baby boomers as the most populous generation in the U.S. years ago, and this massive cohort is on the hunt for homes to raise their growing families.

No wonder the market is hot!

No, it’s not a housing bubble. So what’s in store for the future?

Climbing home prices bring back memories of the housing crisis that led to the Great Recession a decade and a half ago. But just because a market is hot does not mean there is a bubble.

The bubble in home prices that preceded the housing crisis was driven by irresponsible lending practices, rampant speculation, and a complete lack of understanding related to what was driving the market.

Today’s market is different, and there are logical explanations for it. Competition among motivated buyers for too few homes is leading to bidding wars which send prices higher. Spiking mortgage rates have barely made a dent in demand. As some might say, the fundamentals are strong.

Does this mean we’re destined for rapidly increasing home prices in the future? It’s hard to say, but probably not.

The primary reason is the Federal Reserve. The recent surge in mortgage rates is due in no small part to the Fed’s attempt to rein in inflation by slowing the economy. As the Fed continues to raise interest rates, mortgages will become more expensive which will likely have at least some cooling effect on the market.

The question remains to what extent the Fed’s actions will impact the market. That will depend on the amount of corrective action it will end up taking to get inflation under control for the entire economy. Right now, the Fed is just getting started. It’s too early to tell.

Stay tuned, more to come.