The Correlation Between the Real Estate Market and Interest Rates
In order to understand the correlation of the real estate market and interest rates, it is useful to have an understanding of the basic structure of the mortgage market.
Mortgage Ownership
When an individual decides to purchase a piece of property, he usually borrows a certain percentage of the sale price from a lender. The lender, or loan originator, is a bank, credit union, or mortgage broker. The loan originator negotiates the loan terms with the borrower. One of the negotiated terms is the interest rate. Often, interest rates are relatively stable from one originator to the next as the interest rate helps determines the originators profit margin on the loan. Once the loan is finalized, the originator usually sells the loan to an aggregator on the secondary mortgage market. Aggregators can originate loans. Aggregators pool together similar mortgages to form mortgage-backed securities (MBS). An MBS is a bond secured by the value of the aggregated mortgages. The bonds are then offered to investors. The price that the investors will pay substantially influences the interest rate that originators can offer for the mortgage and the price that aggregators will pay for the mortgage.
Fixed-Rate Mortgages
A fixed-rate mortgage's interest rate remains at the negotiated rate throughout the life of the loan. Fixed-rate mortgages are commonly amortized over a 30-year span. An MBS that comprised of 30-year fixed-rate mortgages is closely tied with the prices of a five-year US Treasury note or a 10-year US Treasury bond. While the mortgages are amortized over thirty years, their average lifespan is actually about seven years. This lifespan places such mortgages in line with the lifespan of a 10-year bond. During periods of inflation, the value of Treasury notes and bond decreases, causes interest rates to rise. Rising interest rates directly affect an individual’s ability to borrow money for real estate, as the payments dramatically increase with rising interest rates.
Adjustable-Rate Mortgages
Adjustable-rate mortgages are calculated by adding an index value and a margin. The index value is based on the current interest rate of a traded financial security, bank loans, or bank deposits. These indices are based on short-term rates that can fluctuate monthly, every six months, or once per year, depending on the loan’s terms. The originator determines the margin. The margin is that part of the mortgage that is the originator's profit. When the index is 6.5%, and the margin is 3%, the interest rate is 9.5%, for the first term of the loan. The index is re-calculated according to the terms of the loan, and the interest rate rises and falls accordingly. Most adjustable-rate mortgages have a cap. A cap is the maximum amount that the interest rate can fall or rise in any given term.
Conclusion
Real estate values and interest rates are closely entwined. When interest rates rise, the average, middle-income individual can be priced out of the market fairly quickly. High interest rates encourage the middle class to rent real estate rather than buy it. High interest rates can cause a decrease in property values, as many individuals are unable to afford to buy property. Properties stay on the market longer, further decreasing their value and creating a buyer’s market for those who can afford to buy. Conversely, low interest rates can cause an increase in property values. Low mortgage rates ensure that the average person can afford to purchase property, creating a seller’s market.