Mortgage rates have been scraping the cellar floor in recent years, bottoming out at around 3.5 percent for 30-year loans. Economics 101 says cheap money can't last forever and, sure enough, goverment backed mortgage giant Freddie Mac reported last week that fixed rates jumped, now up a full percentage point, to 4.5 percent
For the average homebuyer, that's not trivial. On a $270,000 loan, roughly the national median price of a single family home, it will boost monthly interest payments by around $125 a month. That could be just enough to deter a first-time homebuyer or to eat into the savings of families trying to refinance their homes before rates get any higher.
In housing finance circles, there's been a lively debate over the recent surge in housing prices: Is the sector's recovery real – that is, built on market fundamentals? Or are we seeing yet another housing bubble inflated by the Fed's policy of monetary easing?
Surging interest rates – and all indications are they aren't going back down – will likely give us the answer by testing the resilience of U.S. housing markets. Here are some key indicators housing experts will be keeping their eyes on:
What happens to credit that many claim is already too tight? The idea that credit is too tight – that capable borrowers can't get mortgage loans despite low interest rates – is widespread, but is it really true? In fact, the real issue may be bank origination capacity, not credit.
Sure it's harder to get a mortgage loan now, but shouldn't it be? No one wants to go back to the days of "liar loans" and "heartbeat approvals." We hear horror stories about lenders who demand endless documentation, but could this simply reflect a resumption of rigorous underwriting in the mortgage industry?
The more prosaic explanation has to do with overstretched banks, which have been operating at peak capacity since the financial crisis. Homeowners have lined up to refinance and take advantage of rock-bottom interest rates. And as President Obama's refinance program has ramped up, there's been an increase in quick transactions that required little documentation and no appraisals. Loan officers have spent more time on refinancing, which is simple, and less on the more thorny and complicated process of getting new home loans through the pipeline.
Thanks in significant part to refinances, banks are booming. But, as mortgage rates increase, the pool of refinancing applicants vying for a bank's attention will diminish. To compensate, banks will have to fill the pipeline with new business to sustain record profits. The likely result will be an expansion of credit as they look to bring in new customers, and credit guidelines will begin to loosen up again.
When there's a glut of potential borrowers, banks can cherry pick the most credit-worthy. But as rates increase, they'll probably be forced to open the credit tap a bit wider, and this will allow more borrowers who may have previously not qualified, to obtain mortgages.
What if the investors disappear? Another force many believe has been the prime driver of a housing recovery are investors. From mom and pop retirees all the way to giant hedge funds, certain cities have seen hordes of private investors, many who have the resources to make all cash offers, come racing to town and drive up prices. It's hard for average homebuyers to compete with these deep-pocketed financiers.
But while cash investors have flocked to the housing market because low prices and increasing rents made this a great time to invest in homes, low rates also meant investor cash had limited places to seek higher returns. Rising rates will change all that. As rates increase and house prices keep rising, often dramatically, investor returns will begin to diminish, and that means that money will need to find other assets that offer higher returns.
That's not all bad. It will allow working families previously pushed out by investors to come back into the market and start buying homes.
So will rising mortgage rates abort the housing recovery? Not likely. Assuming we aren't talking about more big jumps like we saw last week, housing markets should be able to absorb gradual increases. In fact, higher rates could cool down some overheated markets, such as we've seen in Phoenix, where housing prices have been soaring at more than 20 percent a year. A slowdown in price increases seems more likely than the dramatic drops – 30 to 40 percent – that followed the popping of the housing bubble in 2007.
What's more, people who have been sitting on the sidelines waiting for rates to go even lower will likely jump back into housing markets once they realize that rates are headed north instead. This would offset, at least for a while, the contractionary effects of higher rates.
Housing markets likely will be buffeted by such push-pull factors for years to come as they seek a "new normal." Ultimately, Economics 101 says rising mortgage rates reflect a strengthening economy, and that should be good for all sectors.