History shows that falling mortgage rates make housing less, not more, affordable

From financial experts to would-be homebuyers, everyone seems to welcome an almost unanimously expected drop in mortgage rates in 2024.

But if history is any indication, those aspiring to buy a home should be careful what they wish for.

Creditnews Research studied how home prices historically reacted to changes in mortgage rates and found that falling rates typically make housing less affordable, offsetting any savings in financing costs.

With chronically low housing inventory, any increase in demand caused by lower mortgage rates will likely drive up prices in the limited pool of available houses, potentially offsetting any savings from lower mortgage rates.

Dwight Cass

Analyst at Creditnews

What historically happened to house prices when mortgage rates fell

Creditnews Research studied how changes in 30-year fixed-rate mortgage rates affected housing prices between 1987 and 2023 and found that house prices rose in 201 months, or 80% of the time, when the rates fell.

Conversely, house prices fell only 20% of the time during periods of falling rates over the same timeframe.

Not only that, house prices dropped only when the monthly decline in mortgage rates exceeded 0.4%. However, such drops accounted for only 2.40% of the months measured.

In fact, housing prices and mortgage rates fell together only during the three major housing crises in that period—the savings and loan crisis, the Great Recession, and the Covid crisis.

Some experts argue that there’s a lag effect between mortgage rate changes and their impact on housing prices.

This makes sense, as buying a house is a process that can take months to complete, involving the decision to buy, choice of a house, securing a mortgage, and signing a contract.

But even with the 2-year lag factored in, mortgage rate declines were associated with house price growth over five times as often as they were with house price declines.

Mortgage rates are not likely to go lower than 6.5%

Even if the Fed cuts rates in line with the market's expectations, it is unlikely that mortgage rates will fall below 6.5% in 2024. That’s partly because banks need to ramp up their hiring and logistics to deal with a higher volume of mortgage demand.

Jay Bacow, Co-Head of Securitized Products Research at Morgan Stanley, mentioned on a recent episode of the firm’s Thoughts on the Market podcast, “Lenders don't really drop the primary rate as fast as a secondary rate goes down because they're not going to be able to deal with the added volume of inquiries until they add staffing.”

But there’s another reason for the 6.5% floor.

Currently, banks are earning 5.4% on the reserves they hold at the Fed, which are risk-free. If the Fed cuts rates, including the rate it pays on reserves, by a total of 1.50 percentage points, as the market expects, banks will be more willing to shift some of those funds into mortgage lending.

A 6.5% mortgage rate is considered the minimum necessary to entice banks to take the extra risks that rates might rise again, making their 6.5% mortgages less valuable because rates and prices on debt instruments move inversely.

The 6.5% mortgage rate won’t likely fix supply

According to a recent Creditnews report, only 6.4% of existing mortgages have rates above 6.5%, while over two-thirds of mortgage holders locked in rates below 4%.

This means that most people considering selling their houses would be trading into higher-priced houses with higher-interest mortgages, even if they secured one at 6.5%.

Morgan Stanley and Redfin economists, therefore, expect only a slight increase in the supply of housing, enough to result in a 2-3% drop in prices. Compared with the nearly 40% run-up in prices since the start of Covid, that’s a small comfort for buyers.

However, even this would be a historical anomaly.

Morgan Stanley’s housing strategist, Jim Egan, explained on the firm’s podcast, “The affordability improvement that we were expecting to see over the entire course of 2024 is something that we've only seen seven or eight other times in the past 40 years.”

“In most of those instances, sales volumes actually fell during that first year of affordability improvement. When you combine that historical experience with the fact that despite this improvement in affordability, it's still very stretched and for-sale inventories are still very low,” Egan added.

The relationship between mortgage rates and affordability

Depending on how much lower mortgage rates spur demand, they can have a crushing effect on the affordability of a home.

Here’s a real-world example comparing 2013 (after the housing market had mostly recovered from the Great Recession) and 2022 ( during the Covid housing bubble.

In 2013, the average house price in the U.S. was about $240,000, and the average mortgage rate was about 3.5%. With a standard 20% down payment, that meant the buyer needed a $192,000 mortgage.

Adding in tax and insurance, the average house (assuming the down payment came out of savings) cost $1,208 a month.

In 2022, the average house price was about $360,000, and the average mortgage rate was about 2.6%. With 20% down, the buyer needed a $288,000 mortgage to buy the same house.

Including tax and insurance, the house that cost $1,208 a month for a buyer in 2013 now costs $1,672 a month.

Even if prices do not rise, after a 50% run-up in the price of the average house between 2013 and 2022, a fall in mortgage rates is not going to make much of a dent in affordability.

A $500,000 loan at the 7% mortgage rate being offered in late 2023 would mean a $3,300 mortgage payment before taxes and insurance. If rates do settle at 6.5%, that would mean a $3,160 mortgage payment—a savings of only $140 per month.

Youngest homebuyers bear the brunt of low housing affordability

This is particularly bad news for young, first-time buyers in the Millennial and Gen Z demographic cohorts.

According to a recent Creditnews report, despite being the largest generation entering their prime homebuying age, millennials still own a mere 18.2% of real estate wealth—a far cry from boomers' 41.6% share.

More worryingly, a significant number of young would-be homeowners have given up on ever owning a home, according to a Redfin poll published in September 2023.

18% of millennials and 12% of Gen Zers polled by the real estate company’s analysts said that they believe they will never own a home, and half of both groups said they will not be able to purchase one soon due to affordability issues.

The numbers suggest their caution is warranted.

The stock of U.S. houses for sale is 5.5 million units short of potential demand, according to the National Association of Realtors. So, any increase in demand driven by lower rates will likely ramp up prices in the limited pool of available houses, potentially offsetting any savings from lower mortgage rates.