Inflation plowed ahead at its fastest 12-month pace in nearly 40 years during December, according to a closely watched gauge the Labor Department released Wednesday. The stock and bond markets are suddenly awake, with mortgage rates skyrocketing almost 4% from a low of 2.75%.  What is causing the sudden jump in rates?  What does this mean for real estate values and sales? Is there a magic number that will drastically alter sales?

What was in the data?

The consumer price index, a gauge that measures costs across dozens of items, increased 7%, according to the department’s Bureau of Labor Statistics. On a monthly basis, CPI increased 0.5%. Economists surveyed by Dow Jones had been expecting the measure to increase 7% on an annual basis and 0.4% from November.

The annual move was the fastest increase since June 1982. Excluding food and energy prices, so-called core CPI increased 5.5% year over year and 0.6% from the previous month. That compared to estimates of 5.4% and 0.5%. For core inflation, it was the largest annual growth since February 1991.

Shelter costs, which make up about one-third of the total rose 0.4% for the month and 4.1% for the year. That was the fastest pace since February 2007.

What is happening to mortgage rates?

The chart above tells the story with interest rates.  The market has finally awoken to the fact that inflation is not transitory, and the federal reserve will begin raising rates sooner than anticipated just a few months ago.  The consensus is between 3 to 4 rate hikes, but the market appears to be pricing in around 2 at this point.  Assuming 4 hikes, as suggested by Goldman Sachs, this puts mortgage rates closer to 4.5% by the end of the year.  This is a 24% increase in payments from just last year when rates were 2.75%.

Quick example of the impact of higher rates on prospective borrowers:

I assumed the bottom of the mortgage market was around 2.75% and took the current rate of about 4% to compare the impact to borrowers in 3 cities based on median home price.  Furthermore, based on the prospective hikes, that should put rates around 5.25% sometime in 2023.  Below is the cost to individual borrowers.

As you can see, the increased rates will have a huge impact on borrowers in all markets, but even more so with borrowers in high-cost markets where mortgage payments will jump around 1k/month for the median home in Denver.

What is the magic number for mortgage rates that will impact housing prices?

At some point rates rise high enough that sales begin to decline, and prices adjust as a result.  Unfortunately, there is no hard and fast rate that anyone has done substantial research on that will cause the market to suddenly slow but there is a range that will alter the market.  From the data above, when rates hit North of 5%, I suspect consumer behavior will start to change. Rates above 5% will lead to a 35% increase in payments for borrowers.  The last wage report showed and average increase in salaries increasing around 5%, yet at the same time, mortgage payments could jump 35%.  I’m doubtful the market would absorb this increase without seeing some lower prices or at the very least no further price appreciation for a while.

 Summary

At the Fed’s most recent meeting in December, Powell said the central bank is rapidly accelerating its efforts to tighten credit with the goal of reining in inflation. Housing prices and mortgage rates have a historical correlation. As rates rise, sales tend to slow.  At the same time if rates rise high enough values will soften as less people can now afford the same property.  We are already seeing a jump in rates from a low of 2.75% to around 4% today.  Unfortunately this recent upward march in rates is just the beginning.  As rates cross the 5% threshold look for housing to feel the impacts.  How broad these impacts are will be dependent on how high above 5% rates get before the next economic cycle begins.

Additional Reading/Resources:

1. Will Rising Interest Rates Cause Home Prices to Crash in 2022? | The Motley Fool
2. Housing market: Experts debate what rising mortgage rates mean for 2022 home prices | Fortune
3. Goldman Sachs now thinks the Fed will hike rates four times in 2022 and start slashing its balance sheet in July (msn.com)
4. Equity Index Futures Pick Up Steam After Stunning CPI Data (forbes.com)

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Written by Glen Weinberg, COO/ VP Fairview Commercial Lending.  Glen has been published as an expert in hard money lending, real estate valuation, financing, and various other real estate topics in Bloomberg, Businessweek ,the Colorado Real Estate Journal, National Association of Realtors Magazine,  The Real Deal real estate news, the CO Biz Magazine, The Denver Post, The Scotsman mortgage broker guide, Mortgage Professional America and various other national publications.

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