Why Do Interest Rates Affect the Real Estate Market?

Why do interest rates affect the Real Estate market?

The answer is easy. Effective Purchasing power. The majority of retail purchasers in the RE market pay with leveraged funds, or bank loans (mortgages). Every time interest rates change, the payment changes. The “hot” Portland market we are seeing today is due to a combination of low supply and high effective purchasing power. Interest rates are so low that mortgage payments are less than what rent payments would be. This becomes a large decision making factor for the average buyer. Let’s take buyer moving up in inner Portland, for example. Say they’re buying a $500,000 home in Hawthorne. They put 20% down and have a mortgage of $400,000. Even a 1% change in interest rate adds an additional cost to the loan of $4,000 per year, or $333.33 per month. Now, a 1% difference per year in finance costs may not make or break a buyer’s decision on purchasing a home or how much they’ll pay. However, lets consider a 2% ($666.66 per month) or 3% ($999.99 per month) increase in rates. When you’re sitting at a market rate of around 4%, a 2-3% increase in rate makes a large difference in your monthly and yearly finance costs. (That’s 50-75% of the current rate being charged.)

The fact is the real estate market has evolved over the past two generations. This is not our father’s market or our grandfather’s market. This is a highly leveraged industry at this point. Homes are still purchased with cash and owners still participate in the financing market in which case market rates have less of an impact (zero for cash purchases) on a purchaer’s buying decisions. Market rates will somewhat dictate the interest for an owner financed transaction, but terms with an owner financed property can be much more favorable to the buyer than a bank loan.

Why do I bring this up? Because there is uncertainty in the bond market right now which directly correlates to interest rates. As the Fed starts changing paths with QE and as the economy improves, inflation rates will increase, interest rates will increase and buyers may see a substantial change in their disposable income. Higher interest rates mean less disposable income.

We’ll see what happens, but interest rates can’t stay this low forever. Eventually they will have to go up and that will start to affect the RE market. Whether or not that keeps current home owners from “moving up” or slows the demand for first time home buyers has yet to be seen and probably won’t be seen this year. However, as rates start to increase, expect our RE market to slow.

Mike Nuss

Leave a Reply