Thursday, February 09, 2006 | Editor’s Note: This article has been modified since its original publication. Please refer to the note below for an explanation of the correction.

It is a fairly common tactic among housing-industry cheerleaders to cite low interest rates as an “economic fundamental” underpinning current housing prices. Or, putting it in less esoteric terms: Lower interest rates mean lower monthly payments, and lower monthly payments justify higher home prices. Therefore, low interest rates should make homes more expensive.

That this point of view is widely accepted is unsurprising. It is seductively simple to think that sale prices are irrelevant as long as monthly payments remain reasonable. The theory is lent further support by the fact that the most frenzied phase of the housing run-up took place during a period of generational-low interest rates.

But there are some problems with the argument that low interest rates should result in higher home prices.

If one treats a home as an investment – and it seems very clear that most San Diegans do view their homes as investments – then the cost of financing that investment is irrelevant.

After all, if I lend you money one day to buy a stock, and then the next day I lower the rate I am charging you for the loan; did the stock suddenly become more expensive on that second day? It sure didn’t. So why should a house be more expensive based on the rate at which one can borrow money to purchase it?

As a matter of fact, this same reasoning applies whether you consider the home an investment or not. If the checker at your local Vons charged you extra for that box of Cap’n Crunch because he found out that the bank had lowered your credit-card rate, would that go over well with you? Apparently the housing permabulls wouldn’t mind, because the monthly payments on the Cap’n Crunch stayed the same.

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Graph: Rates and prices

Another problem with trying to characterize low rates as a fundamental is that they are unlikely to stay low for long. Given markets’ inexorable tendencies to revert to average valuations, the fact that interest rates got extremely low from a historical standpoint rendered it almost inevitable that they would rise.

And they have risen, although they are still quite low and will likely rise more.

Where does the change in interest rates fit in with the idea that sky-high home prices were being supported by low rates? Now that rates have risen somewhat, and monthly payments with them, does this imply that home prices should have declined? If and when rates rise further, should homes prices drop even more? I haven’t heard any of these questions addressed by members of the “low rates beget expensive houses” school of thought, who apparently feel that interest rates are only a fundamental economic factor when they are extremely low.

The idea that the costliness of San Diego housing is justified by low interest rates is starting to sound more and more unreasonable. But just to be safe, let’s see what the historical record has to say on the matter.

The accompanying charts measure two trends over the past 30 years. The top chart displays the “expensiveness” of San Diego housing (defined by San Diego’s median home-sale price divided by its per capita income – in other words, how much people are willing to pay for homes in comparison to how much they earn). The bottom chart shows the average rate on a 30-year fixed rate mortgage. The shaded squares highlight periods when the two trends were moving in the same direction.

What the chart very clearly shows is that, more often than not, rates and real (inflation-adjusted) home prices have moved in the same direction to one another. Falling rates have not rendered housing more expensive, as our bullish friends contend, but rather have tended to coincide with falling real home prices. Conversely, rising real home prices have tended to coincide with higher, not lower, rates. All in all, real home prices and interest rates moved in the same direction 62 percent of the time.

To be clear, interest rates matter. Lower rates do increase an asset’s intrinsic value to some degree, as they increase the “present value” of income derived from that asset. But given that low rates usually accompany tougher economic times, the bump to a home’s intrinsic value is usually less important than the economic climate when it comes to setting an actual price for that home-as the above chart demonstrates.

Unusually low rates have also been important in that they’ve recently allowed San Diego homebuyers to bid home prices up to previously unimaginable levels. But the speculative excess enabled by low rates will prove neither healthy nor long-lasting.

The idea that low interest rates should make homes more expensive is neither logically sound nor supported by the historical data. There are many fundamental factors that legitimately and sustainably influence home prices, but the level of interest rates is not one of them.

UPDATE: Some readers correctly pointed out that the original version of this article didn’t make a proper distinction between the ideas of “inflation-adjusted cost” and “fundamental value.” The article has since been amended so that the former concept is always referred to as “real cost,” “inflation-adjusted cost,” or “expensiveness.” Additionally, a paragraph was added to explain why interest rates’ effect on fundamental home values should not be expected to translate to home expensiveness.

Rich Toscano is an independent real estate analyst residing in Hillcrest and working in La Jolla. He writes extensively about San Diego housing at

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