San Diego homes are pricey: Compared with local rents and incomes, they are more expensive than at any time outside last decade’s housing bubble.
But monthly home payments are a different story. Thanks to uncommonly low interest rates, mortgage payments have remained pretty reasonable even in the face of increasing purchase prices.
The chart below shows a measure of how expensive the typical San Diego monthly house payment has been relative to local rents and incomes, which make for a good comparison because they represent the most important drivers of home price changes. Despite unusually high home purchase prices, San Diego monthly payments are actually less expensive versus incomes and rents than they’ve typically been over the past 40 years. In fact, the only time payments have been this low outside the post-housing crash period was during the late 1990s, when home valuations were nearly as cheap as they’ve ever been.
It’s reasonable to wonder whether low rates, should they persist, will help keep home valuations at these lofty levels. Maybe — but in the past, the relationship between rates and prices has actually been pretty spotty.
Mortgage Rates Aren’t a Big Driver of Home Valuations
Lower rates lead to lower monthly payments, allowing buyers with a given monthly budget to afford a more expensive home. Higher rates have the opposite effect. So it might seem intuitive to believe that rates should have a really big impact on home purchase prices. In fact, this has not historically been the case.
Below is a graph of home purchase price valuations alongside mortgage rates. If rates were driving home valuations, you’d expect these two lines to move in opposite directions. But they don’t. For example, homes have gotten pretty expensive when rates were sky-high (early 1980s), dirt cheap when rates were middling (late 1990s) and reasonably cheap when rates were at all-time lows (early 2010s). There isn’t much of a discernible relationship in this graph.
Another way to view the interaction between rates and valuations is with a scatter graph, which plots each month’s interest rate on one axis and its home valuation level on the other. There appears to be a bit of a correlation here, but it is quite weak, and is at least partly owed to the housing bubble, which took place at a time of low-ish interest rates.
So while the idea that home prices should move inversely to interest rates is commonly held, it hasn’t really played out that way. Here are some potential reasons why:
• There is other stuff going on too. Changes to the economy and buyer sentiment have a big impact on home valuations. Sentiment in particular is subject to huge swings that can overwhelm all other factors, as we saw during the bubble and ensuing crash. And these factors tend to change in a way that offsets rate changes: Periods of strong economic growth and high confidence are often accompanied by higher rates, and vice-versa. While rates surely exert some influence on prices, they are just one piece of the puzzle.
• The inflation-protection value of home ownership offsets rate changes. One reason to buy a home is to protect yourself from future inflation in the cost of renting or buying a place to live. The value of this aspect of home ownership varies based on expected inflation: If inflation is expected to be high, it’s more valuable to lock in your housing costs, which (all other things being equal) justifies a higher purchase price. Low rates imply low inflation expectations, and less value to the inflation-hedge characteristic of home ownership. This inflation-protection factor should partially offset the impact that rate changes have on monthly payments.
• Buyers don’t expect rates to stay constant. To the extent that rates are a factor in pricing homes, buyers need to consider both the current rate, and the rate when they eventually sell — which could be drastically different. It may be that the housing market has priced in not just current rates, but expectations for a range of possible rates in the future.
• Some costs are more sensitive to purchase prices. Many costs of buying a home, including down payments, property taxes, insurance and transaction fees, are based entirely on purchase price and not impacted by changes in mortgage rates.
There are several reasons to believe that the relationship between prices and rates might not be cut and dried — and on the whole, it hasn’t been.
And yet, here we are with very low rates keeping monthly payments reasonable even as home purchase prices are among their most expensive in (non-bubble) history. Perhaps low rates are propping up prices this time around, and perhaps they will continue to do so for some time. But before citing low rates as a reason to dismiss high housing valuations, it makes sense to consider the historically inconsistent relationship between the two.