In this episode of the REconomy Podcast™ from First American, Chief Economist Mark Fleming and Deputy Chief Economist Odeta Kushi explain why homeowners are protected from shelter cost inflation, but potential home buyers are not, and how rising mortgage rates is likely to further reduce the historically low supply of homes for sale.
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Listen to the REconomy Podcast™ Episode 32:
“Existing homeowners have one key advantage over renters because our monthly cost of shelter, our mortgage payment, is fixed. Because most mortgages are fixed-rate mortgages, we've locked in our mortgage rate and, therefore, our monthly mortgage payment isn't changing, even as inflation rises.” – Mark Fleming, chief economist at First American
Transcript:
Odeta Kushi - Hello, and welcome back to another episode of the REconomy podcast, where we discuss economic issues that impact real estate, housing and affordability. I'm Odeta Kushi, deputy chief economist at First American and here with me as Mark Fleming, chief economist at First American. Hey, Mark, I've got a question for you as a homeowner.
Mark Fleming - Hi, Odeta. I'm saying this with a little bit of trepidation...sure, ask away.
Odeta Kushi - Well, the latest Consumer Price Index (CPI) report indicated that prices climbed 7.5% year over year in January. That's the fastest inflation since 1982. And one of the primary drivers of inflation in January was rising shelter costs. The CPI for housing was up 5.7% year over year, which is also the highest rate since 1982. So, Mark, my question to you as a homeowner is, are you feeling this burden of shelter inflation?
Mark Fleming - Odeta, that's a really interesting question. And I assume it relates to our discussion today and what might seem like, honestly, a counterintuitive answer. I am not experiencing any effects of inflation for my largest single monthly expense every year, which is shelter, even though overall inflation is breaking records. And I will venture to guess that 65.5% -- I'm picking up Odeta's statistical precision here -- of Americans aren't feeling that pressure either.
Odeta Kushi - That's pretty specific indeed. And it's also the homeownership rate. I don't think that's a coincidence. Well, you're right that my question is a lead-in to our discussion today. First, I want to mention that inflation is a very real concern, which is negatively impacting many households today. But, Mark, what you're just saying actually illuminates an important point. Housing inflation is mostly detrimental to potential home buyers, but not as much to current homeowners. We'll discuss this point, why more and more homeowners will likely be rate-locked into their homes over the next year, and what that means for supply. But, first, inflation and existing homeowners. Why aren't you, as a homeowner, feeling increasingly cost-burdened but, I, as a renter looking to become a homeowner if I could ever find something to buy, am feeling increasingly cost-burdened?
Mark Fleming - Listeners, I just counted more than 10 hyphens before I stopped in that phrase right there. That was impressive. Odeta, thanks so much. Yeah, I and most of my fellow existing homeowners have one key advantage over renters because our monthly cost of shelter, our mortgage payment, is fixed. Because most mortgages are fixed-rate mortgages, we've locked in our mortgage rate and, therefore, our monthly mortgage payment isn't changing, even as inflation rises. And as mortgage rates go up, coincident with it. Rents, on the other hand, are actually at this moment increasing quite substantially. And landlords can raise rents as leases expire or are renewed. Because so many owners have locked or captured in those historically low rates in the recent past, the current effective rate of interest or mortgage debt outstanding -- mouthfull here -- was 3.4% in the fourth quarter of last year.
Odeta Kushi - The effective rate of what? Say that again. Yes, yes, the effective rate of interest. Let me explain. And we'll go back to an analogy we've used in the past. And let's start by picturing a bathtub. I don't know why I'm always the one that has to do these analogy pictures, but here we go. You're much better at it.
Mark Fleming - Water flows into the tub. And that represents all the mortgage dollars from the borrowers in the market as they buy homes and refinance at the market contract rates. So that's sort of the new stuff flowing in. While the water level in the tub represents the total stock of all the dollars of mortgages outstanding. Keep in mind, those mortgage dollars are coming in at all different points in time and sitting in the bathtub. And so they have different mortgage rates associated with them depending upon when they were the current rate. If you take the average of all of those mortgage rates, or the stock of mortgage dollars in the tub, at a certain point in time, you get the effective rate of interest on mortgage debt outstanding. Basically, because the stock of mortgage dollars includes the new ones flying in, but a lot more already there. Keeping in mind that mortgages spend a lot of time in this proverbial tub because we take a long time to pay them down, over 30 years. So, the effective rate of mortgage interest more accurately reflects the typical or average rate being experienced among all homeowners, just not the new ones that are getting the mortgages today.
Odeta Kushi - I see. Well, many existing homeowners today have locked in rates below 3.5%. Meanwhile, contract mortgage rates are increasing. In the week ending February 10, the average contract interest rate for 30-year, fixed-rate mortgages was approximately 3.7%. So, for potential home buyers like me, not only are our house prices and rent rising, but so are mortgage rates, making it more expensive for me to buy or even to rent, yet the principal and interest on your mortgage stays the same in this inflationary environment. But, coming back to the discussion of the effective rate, how did the effective rate compare to the contract rate in the latest quarter? And what information can we glean from that gap?
Mark Fleming - So, this makes a really interesting point and gets to some of the things we've talked about in prior episodes of our podcasts. If enough existing mortgage holders have mortgages below the current rate, that stock in there, then the effective rate is lower than the contract rate. So, in the fourth quarter of 2021, the contract rate was approximately 3.1%. While the effective rate was 3.4%. That means that more mortgages are below, on average, that current rate than before, and of course, the gap gets bigger, potentially, depending upon the dynamics of what's coming in the top. If we look back in the history of the difference between the effective rate and the current rate, we find that there's a general interesting trend. As current mortgage rates decline, and we've had long periods of time in recent history of current mortgage rates declining, that effective rate essentially trails down and follows the current rate down. Well, why does it do that? Because the financial incentive of the lower borrowing costs, as represented by that mortgage rate, incentivises people to sell and refinance. Using our bathtub analogy, you can think of that as higher mortgages in the bathtub flowing out the drain, as people pay off those mortgages, and then they're getting new mortgages at a contract rate, which is lower than the one that went out of the drain. So the overall effective, or average, rate goes down. This is sort of a replacement process. And when rates are falling, you know, the drain opens up more. More things come off, and more lower mortgage rates come in, and it trails down the other way, but drives down the effective rate. But, when rates increase, the flow out of the drain slows down, probably doesn't stop. We'll talk about that in a minute. But it slows down. Think of it as shutting off the drain. And so the ones coming in the top are coming in at a higher rate. And that is not enough. And so the effective rate sort of stops going down, but it doesn't really go up. And so the contract rate deviates, and the effective rate sort of stays the same. Sort of like, you can imagine this sort of drops down, goes flat, drops down, goes flat, but it has really hard time going back up the other way. And that's because the financial incentive to sell or refinance goes away and the effective rate difference basically shows that relative to the contract rate.
Odeta Kushi - Well, you did a great job explaining that. And that sounds a lot like evidence of the rate lock-in effect. Homeowners who have locked into the super-low rates have a financial incentive to stay put. And the higher mortgage rates go, the more locked in these homeowners will be. In some ways, that's good, because they won't experience that shelter inflation. And, in fact, existing homeowners actually benefit from equity appreciation. But, there's a clear downside here, because if existing homeowners are feeling rate-locked in, then they won't sell their homes. And, as we know, the majority of home sales are sales of existing homes.
Mark Fleming - That's right, and great for homeowners, but they're the largest source of the inventory for sale. And this is one reason why inventory is currently at historic lows. While existing homeowners are sitting on these high levels of equity and feeling wealthier, many of them have also secured those low mortgage rates. This financial lock-in effect increases as the mortgage rates rise and the size of the mortgage increases. That's why move out, if you must move down, or pay more to move up.
Odeta Kushi - So rising rates may keep existing homeowners staying put, while inventory is sitting at a historic low. And it's a bit of a self-perpetuating cycle because the other supply constraint is rooted in the uniqueness of the housing market. And we've talked about this before, where, in most markets, the seller makes the decision to add supply to the market independent of the buyer. Yet, in the housing market, the seller and the buyer are in many cases the same person, the existing homeowner. To buy a new home, you must also sell the home you already own and then find a home you like better. So, when supply is constrained as in today's market, it becomes really difficult to find a better home than what you already own. The existing owner faces the dilemma of whether to sell or not when they fear not being able to find something to buy. So, what is all of this mean for the upcoming spring home-buying season?
Mark Fleming - That's right. The economic term that we try to avoid, and that you just described is --heterogeneous good. Housing, fortunately or unfortunately, is a practically perfectly heterogeneous good. And so it matters what's available for sale because not anything is a suitable or attractive replacement. And, while we do believe that existing-home inventory will still likely pick up ahead of the spring home-buying season this year because people make the decision to sell and buy for many other reasons than just the purely financial -- we've made the joke about, you know, being rational economic behaviors. That's not necessarily the case when it comes to our home-buying decisions. They want to move to a different city, buy a bigger and better home, or downsize for lifestyle reasons. There are plenty of good reasons why that inventory does tend to pick up in the spring. But it's still likely that it will remain true in 2022 that there will be more supply, but it still won't be enough, and just not as much as when mortgage rates are falling.
Odeta Kushi - So, still a little bit more supply coming this spring, but not quite enough to meet demand so still putting that upward pressure on prices. Alright, well, perhaps a recap is in order before we wrap up. I think we talked about a lot in this episode. The first, shelter inflation is on the rise, but existing homeowners, which is nearly 66% of Americans, will not experience it, but potential first-time home buyers sure will. As rates continue to go up, existing homeowners will have less incentive to sell, putting downward pressure on inventory. That means it'll likely be another competitive spring home-buying season. But, as we've discussed in previous episodes, if affordability continues to decline, it will prompt some buyers to pull back from the market and bidding wars to subside, which will result in a moderation of house price growth. Well, that's it for today. Thank you for joining us on this episode of the REconomy podcast. If you have an economics-related question you'd like us to feature on a future episode, you can email us at economics@firstam.com. We love to hear from our listeners. And be sure to subscribe on your favorite podcast platform. You can also sign up for our blog at Firstam.com/economics. And if you can't wait for the next episode, you can follow us on Twitter. It's @OdetaKushi for me and @MFlemingEcon for Mark. Until next time.
This transcript has been edited for clarity.
