Economics question?

Question

Explain how low interest rates have affected the recent housing market.

Answer 1

Low interest rates helped to accelerate the increase in housing prices, to the point of causing something of a real estate bubble that perhaps is now in the process of correcting.

The reason is: interest rates affect the monthly cost of a mortgage. Assume the average household can afford to spend, say, 30% of its income supporting a mortgage. With lower interest rates, this 30% will buy a more expensive house than in the case of high interest rates. The result is that homebuyers have been able to bid ever higher prices for houses, driving up their prices, but still they could afford the resulting mortgages.

The irony in some cases is that something good for consumers (low interest rates) has led to a situation that is bad for consumers (their house losing value in markets that are correcting, & them losing money when they sell).

Answer 2

If you go back to the beginning of CPI data on housing and look at the "owner's rent" for a home. In essence, the owner's equivalent to renting. It has tended to rise with wages and wages have tended to rise with the CPI. So, for example, if you had wages of $1000 before and lenders will let you borrow 33% of your wages, then you could make a $330 per month payment. Now, if you have $2000 per month in wages you could borrow $660 per month. However, if your wages simply kept up with inflation, the surprise you would get is that the house you would buy is already identical to the house you own, ignoring local demographic changes which can be large.

So, from inflation alone, there are no changes. However, lets imagine that you could borrow that money in 1982 when rates were double digit rates. Almost all of the original $330 went to interest whereas the $660 would have a significant principal component due to low rates.

As a consequence, when you factor in both inflation and the impact on borrowing rates of the change in inflation, nearly 100% of housing prices can be explained by these two factors alone.

This is important because someone who was borrowing at 15% and now borrows at 6% has seen significant appreciation. But, borrowers at 6% who end up seeing higher rates later on will see less than inflation based increases in the value of their home. In essesence it is much riskier to buy a home today in a low rate environment than in a high rate environment.

As an experiment, look up the CPI on housing and the Federal Reserve and FHLBB data on housing in the early 80's vs. today. Then imagine a 30 year mortgage for both with 20% down.

So low rates have permitted a large increase in the price of housing. They have also increased the risk of homeowing substantially. It has permitted people to own homes who would not otherwise own a home. It has also reduced the value of rental property significantly. In many markets there is a greater value in renting than there is in owning. This is historically the opposite of what has been the norm.

Answer 3

Low interest rates means people can borrow money cheaper (mortgages, etc) so are more likely to buy houses.
Hence house prices rise.

Answer 4

a low level of interest means that the housing finances are cheaper now. people can go for home loans more.