High interest rates and mortgage lock-in

The Federal Reserve held interest rates steady this week and signaled potential rate cuts in the near future. However, the current high interest rates may be creating unintended consequences for the housing market. Julia Fonseca, an economist at the University of Illinois at Urbana-Champaign, noted that as of March, around 60% of people with mortgages had rates below 4%. In contrast, the current average rate for a 30-year fixed mortgage is nearly 7%. This disparity has led to a phenomenon known as mortgage lock-in, where homeowners are reluctant to move because their mortgage rates would nearly double. “Mortgage lock-in is still very much alive,” Fonseca stated. “Many people want to move to a different city or a bigger house, but it’s hard to give up these low rates.” Fonseca and her colleagues investigated the effects of mortgage lock-in on the housing market. They found that lock-in is not only reducing demand—because people with starter homes are staying put—but also affecting the supply side, leading to fewer existing homes available on the market. “So you’re at the same time taking out both supply and demand,” Fonseca explained. “The net effect on prices, however, has been an increase.” What Julia and her co-authors discovered is that higher interest rates, meant to cool off the economy and reduce inflation, are paradoxically leading to higher home prices by impacting the supply side more significantly. “This implies that raising interest rates from low levels to fight inflation will itself create some inflation through housing markets,” she said. Adding to the complexity, homebuilders cannot easily mitigate this supply issue. Their business model requires borrowing before building, and higher interest rates make borrowing more costly. The shortage of starter homes also impedes renters’ ability to move up the housing ladder.

Effects of mortgage lock-in phenomenon

This increased demand for rental units leads to higher rents. Housing markets vary across the U.S., and in some areas, housing affordability issues existed even before the Fed started raising interest rates. In the Eastern Upper Peninsula of Michigan, the Bay Mills Indian Community faces a micro-housing crisis. Over the past five years, rents and home prices have surged, pushing many middle-income families—earning $30,000 to $60,000 a year—out of the housing market. Whitney Gravelle, President of Bay Mills Indian Community, highlights that housing and child care are top priorities. With rents on some one-bedroom apartments jumping from $400 to $1,200 a month and home prices soaring, many families find homeownership unattainable. The Bay Mills government took assertive action by securing $880,000 from the state’s “Missing Middle Housing Program” to build 11 single-family homes. These new homes, owned by the tribe, are rented to middle-income families at affordable rates starting from $400 to $600 per month. The homes are built on one-acre parcels surrounded by nature, providing a sense of individualism and community. “Despite it being a housing development project that came from the government, the unique colored doors create a more individual atmosphere for the families,” Gravelle notes. In summary, higher interest rates appear to lead to higher home prices, which is a paradoxical situation. Despite this, Fonseca emphasized that this does not imply the Federal Reserve’s monetary policy is ineffective. Rather, it means that the Fed’s task of managing inflation will be more challenging due to the effects of mortgage lock-in. The Federal Reserve will make its next interest rate decision in September, and it remains to be seen if homeowners will begin to unlock from their mortgages by the end of the year.