By Simon J. Lau, CFA
Navigating the Housing Market: Buy Now or Wait for Rates to Drop?
The housing market has always been a hot topic, but with interest rates fluctuating wildly in recent years, it’s more critical now than ever to understand the implications for potential homebuyers. I’d argue that buying a home in a high-interest rate environment offers unique advantages and I’ll explore key factors to consider when making this decision.
Historically, mortgage interest rates have seen dramatic changes. They peaked at over 18% in the early 1980s due to efforts to curb inflation, dropped steadily over the following decades, and fell below 3% by 2020 as a result of economic policies designed to stimulate growth during the pandemic. However, by 2022, rates began climbing rapidly, sometimes nearing 8%, driven by inflationary pressures and the Federal Reserve’s response to rising prices. Currently, they sit at around 7%.
Now, putting aside the countless reasons why one shouldn’t buy a home, if the only thing keeping you from making offers now is that you’re waiting for rates to drop, here are some reasons why I’d put those concerns aside.
Below is an excerpt from an article I wrote in 2019, What Does It Take to Buy a Home in San Francisco? Although market conditions have drastically changed since then, I still stand by this thesis now.
Contrary to popular opinion, the best time to buy a home may be in a high-interest rate environment. In competitive markets where most buyers finance their homes, interest rates significantly impact home prices. As interest rates rise, buyers are approved for lower loan amounts, reducing the amount they can offer and afford. The benefit of buying in a high-interest rate environment is that, as interest rates decrease, homeowners can refinance their homes at lower rates while having locked in a lower purchase price set during the high-interest rate period.
Case Example
To better illustrate this point, I’ve refreshed the example I used in my 2019 article. Imagine a couple with excellent credit and a family income of $400K per year applying for a loan. They are approved for a mortgage using a front-end ratio of 28%. (The front-end ratio in mortgages, also known as the housing ratio, measures the percentage of a borrower’s gross monthly income allocated to housing expenses, including the monthly mortgage payment, property taxes, homeowners insurance, and any association fees. Lenders use this ratio to assess a borrower’s ability to afford the loan, typically aiming for a front-end ratio of 28% or lower. To simplify this example, we’re assuming the only housing expenses are mortgage payments.) This results in a $9.3K monthly payment for principal and interest.
A $9.3K monthly mortgage translates into different mortgage amounts based on interest rates, as illustrated in the graph above. Based on current and historic trends, the following applies:
- If this couple had applied for a loan in 2020 with the same income, they could have been approved for a 3% interest rate mortgage. Assuming a 20% down payment ($443K), they could have purchased a $2.7M home with a $2.2M mortgage.
- Today, if this same couple were to apply for a mortgage, their interest rate would be much higher, possibly as high as 7%. At that rate, assuming 20% down ($281K), they could only afford a $1.7M home (37% lower than in 2020) with a $1.4M mortgage.
- If this couple were to apply the full $443K downpayment described in initial example, they could afford a $1.8M home (31% lower than in 2020) with a $1.4M mortgage.
This illustrates, on a small scale, the significant impact that interest rates can have on mortgages. It may seem obvious, but as interest rates rise, home prices tend to fall, all else being equal.
Other Considerations
The example described above is clearly oversimplified. Interest rates are not the only factor influencing home prices. For example, since interest rates have rapidly increased recently, many existing homeowners with sub-4% mortgage rates are hesitant to sell their homes and buy at current market rates. This has reduced the available inventory in the housing market, causing a freeze in home sales.
Other important factors include economic conditions, such as employment rates, wage growth, and overall economic health, which can influence home buying. During a strong economy, more people have the financial stability to purchase homes, increasing demand and potentially raising prices. Conversely, in a weak economy, job insecurity and stagnant wages can dampen demand, putting downward pressure on prices.
Government policies, including tax incentives, zoning laws, and housing regulations, can also affect the housing market. For instance, first-time homebuyer tax credits can boost demand by making it more affordable for new buyers to enter the market. On the other hand, restrictive zoning laws can limit the supply of new homes, driving prices up due to scarcity.
Local market conditions, such as the desirability of the location, quality of local schools, and crime rates, play a major role in home prices. A neighborhood with excellent schools and low crime rates will generally see higher home prices, while areas with less favorable conditions may experience slower price growth or even declines.
While many more factors could be listed, these are some of the largest drivers.
Looking Ahead
A freeze like this cannot last forever. Specifically, as more homeowners who have been reluctant to sell due to their low mortgage rates start to enter the market, inventory levels will rise. This increase in available homes generally leads to more competitive pricing, driving down home prices. Additionally, sellers might be more willing to negotiate on price and terms to attract buyers, providing further opportunities for those ready to purchase.
However, it’s crucial to consider that interest rates are just one piece of the puzzle. Economic conditions, government policies, local market dynamics, construction costs, and demographic trends will all continue to influence the housing market. By keeping these factors in mind, buyers can make more informed decisions and better navigate the complexities of the housing market.
Disclaimer: The information provided is for informational purposes only and does not constitute financial, legal, medical, or professional advice. Users should consult qualified professionals for advice tailored to their specific needs. The author and publisher are not responsible for any errors, omissions, or damages arising from the use of this information. By using this content, you agree to hold the author and publisher harmless from any claims or liabilities.
