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Your Home: Bracing for higher rates
Interest rates are low now. But when they rise -- and some day they will -- home prices may suffer.
January 29, 2004: 3:20 PM EST
By Sarah Max, CNN/Money staff writer

BEND, Ore. (CNN/Money) - For now, mortgage rates are still near historically low levels.

Interest rates on a 30-year fixed-rate mortgage, the most popular U.S. home loan, averaged 5.58 percent for the week ending Jan. 28, according to the Mortgage Bankers Association (MBA).

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Still, most economists agree that interest rates are going to creep up in the next couple of years.

On Wednesday, in fact, the bond market reacted strongly after the Federal Reserve dropped its promise to hold rates steady for a "considerable period" and instead said that it will be "patient" before raising rates.

What happens to home prices when interest rates rise?

All things being equal, home prices could suffer. After all, buyers who could afford a $1,400 monthly payment on a $250,000 mortgage when rates are 5.5 percent may not be willing to pay as much for a house if rates go to 7 percent, in which case the monthly payment would be $1,660.

"Let's imagine rates go to 7 percent, I think that would take the air out of the bubble pretty quickly," said Dean Baker, co-director of the Center for Economic and Policy Research,

Baker strongly believes there is a housing bubble in many markets, so much so that he's launched a $1,000 essay contest for the person who comes up with the best case for why there isn't a bubble. "I've debated a number of economists and haven't found an argument that's satisfying," he said.

Other economists say the relationship between home prices and interest rates isn't quite as direct. For one, when rising rates go hand-in-hand with an economic recovery, as they often do, better job prospects partially offset the effects of higher rates.

Also, when rates go up, buyers often opt for adjustable rate mortgages (ARMs), which have lower rates than fixed loans. "When rates started picking up after the last refi boom in 1993, people didn't leave the market, they just shifted into ARMs," said Eric Belsky, executive director of Harvard's Joint Center for Housing Studies.

According to David Stiff, director of economic research for Fiserv Case Shiller Weiss, rates went up 2.25 percentage points in 1994. "Price appreciation really slowed but values didn't drop off," he said.

Forecast for the coming years

Last week, the MBA said it expects the 30-year fixed rate mortgage to reach 6.3 percent by the end of 2004 and 7.1 percent by the end of 2005. But, favorable demographics and a growing economy will continue pushing up home prices, according to MBA chief economist Douglas Duncan, albeit at a slower rate than they have risen in recent years.

The median price of an existing single-family home is $174,300 as of the first quarter of this year, according to the MBA. At this time next year, the MBA is predicting, the median will be $180,700, a 3.6 percent increase.

As Baker sees it, however, even a slowing of price appreciation could have repercussions. "People buying in bubble areas are going to look at a house in a different way if they don't think its price is going to go up at 15 or 20 above the rate of inflation," he said.

Overbuilding, meanwhile, could exacerbate the effects of rising interest rates. Although the MBA is predicting that demand for housing will continue to outpace supply, Baker begs to differ.

"We're seeing record rates of home construction," he said. "Eventually you're going to have homes sitting there, and they won't be sold."

Baker isn't suggesting that homeowners run out and sell, though he personally considered doing so. But, homebuyers shouldn't base their decision to buy on the assumption that prices will appreciate as they have been.

"Before you buy, ask yourself whether it's still worth it even if home prices come down," he said.

Some markets, some homeowners, more vulnerable

Though there's never been a nationwide decline in real estate prices, individual markets have suffered plenty -- see "Real estate horror stories."

As such, some markets could surely feel more pain than others. "I'd be most concerned in places where housing affordability is an issue because the effects of rising interest rates are even more pronounced," said CSW's Stiff.

According to the National Association of Realtors affordability index, Boston, San Diego, San Francisco and Washington D.C. were among the least affordable markets as of November 2003. "San Diego has had six straight years of double-digit price increases," said Lawrence Yun, senior economist for NAR.

Among the most affordable places are Buffalo, N.Y., El Paso, Texas, Fort Wayne, Ind. and Peoria, Ill. In these cities, median-income families make more than enough to pay for median-priced homes.

"In cheaper markets interest rates probably won't matter as much as the local economy," Stiff added. "These are places where new supply matches new demand, and you just have steady appreciation."

Home Prices
Interest Rates

Similarly, not all homeowners will suffer the same. If you're not planning to move for years, a decline in home values won't have as much of an impact.

But a decline could be a real problem for Americans who have taken advantage of the run up in prices to do cash-out refinancings. They could very well owe more than their house is worth -- bad news if they are forced to sell.  Top of page

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