How Low Mortgage Rates Help Reinflate Sagging Home Prices

Why you should thank the Federal Reserve for rising real estate values in your neighborhood.

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House on a roll of currency for 10 Things to Know About Getting a Mortgage in 2010 slideshow.

You might have heard rumblings about home prices rising again, even posting double-digit increases in some metropolitan areas. But what you might not know is that the Federal Reserve actually has a hand in the helping the nation's real estate market recover.

[READ: Is Economic Recovery Here? More Americans—And Economists—Think So]

The Fed has repeatedly committed to keeping long-term interest rates low, and based on minutes from its most recent meeting, there's some talk that the nation's central bank could unveil yet another Treasury-buying plan to replace a program expiring at the end of this year. More demand for treasuries fueled by a Fed bond-buying program drives yields on those bonds lower. Because mortgage rates are indexed against Treasury yields, a drop in yields for T-bills means lower interest rates on mortgages.

But how does that help home prices, which remain about 30 percent off their 2006 peak?

If you're a homebuyer, lower mortgage rates open up more expensive properties to your budget—about 20 percent more expensive than you might be able to buy if rates were at, for instance, 5 percent. And since home price measures are based on homes actually sold and the ability to buy more expensive homes is enhanced by lower rates, home prices begin to rise.

[READ: New Home Sales Surge to 2-Year High in September]

Here's how it works: Using "qualification ratios," lenders determine how much of a borrower's monthly gross income can be used to support a monthly mortgage payment. For most borrowers, the ratio is 28 percent.

Let's say your monthly gross income is $3,000—28 percent of that is $840 per month. With a 30-year term and a 5 percent interest rate, that $840 per month will allow you to borrow about $156,000. However, at 3.5 percent interest, that same $840 per month will allow you to borrow about $187,000. (These amounts are reduced when taxes, insurance, and other debts are taken into account.)

Lower rates also lower the income needed to buy that $156,000 home, too. Instead of $840 per month at a 5 percent rate, the 3.5 percent rate only carries a $701 monthly payment and the borrower only needs a $2,500 per month income to qualify for it. This brings more potential homebuyers into the market, increasing demand. That fosters price increases as sellers, seeing more people interested in their property, become more resistant about accepting low-price offers.

[READ: Is Housing Better Off Than It Was 4 Years Ago? Survey Says No]

While there are of course other costs and issues associated with homeownership which might not exist when you rent, including maintenance, a down payment, getting a mortgage, closing costs and more, lower monthly mortgage "carrying costs" can make buying a home very competitive with renting.

This is especially true in markets where rents have been increasing quickly. If you are a renter and find yourself in such a market, study your local real estate market and consider buying a home when your lease comes up for renewal. If you plan on buying a home in the next few years and you decide to wait, the combination of interest rates and price climate ("affordability") might not be as favorable.

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  • Keith Gumbinger of HSH.com is a 25-year expert observer of the mortgage and consumer debt markets. He has been cited in thousands of articles covering a wide range of consumer finance and economic topics in outlets ranging from the Wall Street Journal to the Bottom Line newsletters. He has been a featured guest on national broadcasts for CNN, CNBC, ABC, CBS, and NBC television networks and has been heard on NPR and other national and local radio programs. Keith is the primary researcher and writer for HSH.com's MarketTrends newsletter and has authored or co-authored a number of consumer guides on mortgages, home equity, refinancing and more.