How the ‘lock-in effect’ is helping shape today’s housing market

Trying to buy a house? Good luck.

With mortgage rates at 20-year highs, homes for sale are few and far between, yet prices continue to rise. Are we in another housing bubble? Will home sales and prices collapse? Will we ever be able to afford a house again? Good questions.

What is going on in the housing market? Let’s start with sales.

The existing home market, which constitutes 90% of total home purchases, is fading. Sales did pick up during the pandemic as panic buying and work-from-home relocations led to a jump in demand. But that was a temporary uptick, and the level of new home purchases faded fairly quickly. Indeed, next year sales could be the lowest in nearly 30 years.

As for the new home market, after the housing bubble burst and the financial crisis led to a credit crunch, sales and construction didn’t bottom until 2011. Since then, both have been on a slow but steady recovery path. In 2020, the pandemic created a temporary demand surge, but sales have softened over the past few years. That said, this is not another collapse, but just a recalibration back to levels that are only moderately below longer-term trends. Indeed, recent data indicate that sales are slowly improving again.

Housing prices, though, are a different story. Despite the slowdown in the existing home market, prices continue to rise. It doesn’t matter which index you use — Case-Shiller, Fannie Mae, the Federal Housing Finance Agency, or Zillow — 2023 will likely turn out to be a good year for home sellers. It looks like housing prices will be up between 4% and 7%. That may be slower than we have seen during the past few years, but it is still solid.

The continued strength in home prices appears to make little sense. Demand is down, at least as measured by sales, and critically, financing costs have skyrocketed. Since February of this year, 30-year fixed mortgage rates have risen from about 6.10% to 8%. Home buyers are facing the highest rates in 23 years.

To put that rise in perspective, consider an existing home selling at the national median price of $400,000. With 20% down, that leaves $320,000 to be financed. For a 6%, 30-year fixed-rate mortgage, the monthly payment is roughly $1,920 per month. But an 8% mortgage runs about $2,350 per month, a 22% increase. The resulting higher payments add nearly $5,200 for the year. That is real money and a major drain on household finances.

Let’s review: The cost of financing a house is up and demand is down yet the price of homes continues to rise. In previous housing price bubbles, which didn’t end well, robust demand drove the markets. What is going on now doesn’t make sense — or does it?

The market is different than it has been, which helps to make sense of what’s happening.

Why? the supply of homes, as measured by homes for sale, is way down. It looks like we will end 2023 with inventory shrinking between 10% and 15% over the year.

And that raises the question, why are people not putting their homes on the market when prices have risen so much over the past few years? It’s largely due to the surge in prices and mortgage rates, but not for the normal reasons.

Over the past 10 years, home prices have basically doubled. During that time, interest rates were at historic lows. If you bought a home or refinanced, your mortgage was likely 4.5% or less. Unfortunately, those low-rate mortgages have created a major quandary for homeowners.

If the homeowners sell their house, they can realize the price gains and put the funds toward a new home. But then they have to give up their low mortgage rate and take out a new loan at a significantly higher rate. Going from a 4% mortgage to an 8% one, for a different home whose price has also doubled, creates more financial strain than many people would likely want.

The unwillingness to trade in a low-rate mortgage for a high-rate one, a threat that economists warned about years ago, has been nicknamed the “lock-in effect.” Goldman-Sachs estimated that “nearly all mortgage borrowers have interest rates below current market rates, and that almost 90% have rates more than 2pp below and over 60% have rates more than 4pp below.”

In other words, if you own a home and are thinking of selling and moving to another house, you are almost certainly facing mortgage rates a lot higher than you currently have. That is making most homeowners think twice about entering the market. The soaring mortgage rates have created a financial barrier to selling and moving. Think of it as “Golden Handcuffs.”

And if owners are not willing to sell their homes, the number of homes for sale is going to stay low if not decline as long as rates remain high. This is a problem rarely seen in the past and is why this housing market really is different.

Yet there is a silver, if not gold lining in the housing supply/locked-in situation: Limited supply means home prices are not likely to decline sharply, if they decline at all. Right now, prices are still slowly rising because the strong economy has created solid increases in household income. This is especially true for higher-income households who have the financial wherewithal to purchase the limited supply that is out there.

So, are housing prices going to finally come down soon so more people, especially first-time home buyers are able to purchase a home? Not likely. The combination of surging prices and soaring rates have driven home affordability to 40-year lows. Reversing the impacts of those increases could take years.

Joel L. Naroff is the president and founder of Naroff Economics consulting firm in Margate.