The Rippling Effects of Rising Interest Rates on Housing and the Economy

Housing is one of the major economic issues tracked in our economy and for many good reasons. We track housing starts, housing prices, units available, average days on the market and many other statistics that are used to offer insight into the future of our economy. Home ownership has always been a staple of the American family but things do change.

A major reason we watch home building and buying is because of a concept called complementary spending. That is the notion – a very real reality – that in some cases spending one dollar can literally mandate you spend more dollars.

The concept is simple but has significant impact on our economy. A house essentially has four walls but is relatively useless until it is filled with the things that make it a home; couches, refrigerators, blender, pans, television and so forth. Committing to buying your first home brings with it the added need of investing more dollars in other goods and services. That is complimentary spending.

One reason the concept of raising interest rates is so worrisome to some economists is that most people buy homes based on payments they can afford rather than the total price. As the money required to pay the mortgage payment rises, the owners have less to spend on other goods and services. That is why there is a belief that higher rates slow down the growth of an economy. If more goes to interest, less goes to buying things. When interest rates rise a dollar simply doesn’t go as far.

Looking at a $100,000 home in a simplistic example, we can examine a 3% 30-year mortgage versus a 4.5% 30-year mortgage. The borrower will put down 5% in both examples and finance the $95,000 balance. Using only interest – no taxes, insurance or PMI requirements – the 3% loan has a monthly obligation of $400.52/month. The 4.5% loan requires $481.35 each month. That is a substantial difference which takes us to the next issue: debt-to-income ratios.

The ratio is the amount of your monthly income compared to the amount of your monthly contractually obligated debt repayments. Your car payment, minimum monthly payment on your credit cards, or any other loan you have outstanding including student loans.

A very real world dilemma we are facing as a culture and an economy is that of student debt and its impact on not just housing but many issues. For now, focusing only on housing, a rising interest rate environment, coupled with extremely high student debt repayments is a challenge for first-time home buyers.

History tells us that high interest rates don’t curtail the purchasing of a home but it does restrict the size of home that can be purchased. According to the HS Dent foundation research, the average mortgage interest rate in 1980 was 18%! Some of you may remember those rates while others can’t even imagine what that would be like. People bought homes because that’s what moms and dads do. As incomes rose, debt reduced and interest rates fell, the size of homes increased. Like it or not, everything in the economy is connected.

Disclaimer: Do not construe anything written in this post or this blog in its entirety as a recommendation, research, or an offer to buy or sell any securities. Everything in this post is meant for educational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in the blog. Please see our Disclosure page for the full disclaimer

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