Inflation Increased More Than Expected – Here’s What It Means for Housing Affordability

As U.S. consumer prices rose unexpectedly in March, speculation about the Federal Reserve’s next move has intensified. With a year-on-year inflation increase of 3.5%, the highest in six months, and a core CPI jump of 0.4%, anticipated reductions in interest rates might be postponed, which will impact the housing market outlook.

Persistent inflation might push the Federal Reserve to postpone the expected rate reductions or even increase them. Federal Reserve Governor Michelle Bowman went as far as saying that interest rates may have to move higher to control inflation.

This could lead to stable or slightly higher mortgage rates, maintaining a cautious market atmosphere and potentially continuing the lock-in effect, where homeowners hold onto low-rate mortgages.

The lock-in effect in mortgage rates refers to the situation where homeowners are discouraged from selling their homes or refinancing their mortgages due to the prospect of losing their current low interest rates in a rising rate environment. This has a balancing effect on higher interest rates, which typically cause home prices to drop.

According to estimates by the FHFA, 1.33 million sales were prevented from Q2 2022 to Q4 2023 due to the lock-in effect. A delay in reducing mortgage rates, which is a possibility now, will probably maintain or slightly elevate the lock-in effect, impacting home sales and affordability.

The graph above shows a simulation of the lock-in effect on home sales in four different scenarios. Let’s take a closer look at each one.

Should mortgage rates stabilize at the Q4 2023 level of 7.38%, the lock-in effect is projected to remain significant, reducing home sales by over 40% for the next decade. A large proportion of loans from the Q4 2023 portfolio will remain active, reflecting a slower payoff rate and extending the duration of the lock-in effect.

A hypothetical 1-point cut by the Fed could decrease the lock-in effect to -40% initially, with a potential decline to -20% within ten years. This reduction in the lock-in effect is facilitated by an increase in loan payoffs as newer loans with marginally lower rates enter the market, hastening the normalization process.

While a 2-point rate cut is less probable given current inflation rates, such a decrease would significantly lessen the lock-in effect, dropping it to -20% initially and further to -14% by 2033. This scenario would see the highest rate of loan payoffs, with only 42% of the 2023 Q4 portfolio’s loans remaining active after a decade.

Despite potential indications from the Fed regarding rate reductions in 2024, the ongoing inflationary pressures could lead to a rate hike. An increase of 1 percentage point would intensify the lock-in effect, increasing it from -57% to -71%. Consequently, about 70% of the loans from the 2023 Q4 portfolio would still be active after ten years, indicating a very slow decline in the lock-in effect and significantly lower loan payoff rates.

Overall, these scenarios illustrate that the lock-in effect could persist for a considerable period, particularly if interest rates do not decrease dramatically. The effect varies significantly across different interest rate changes, influencing both the rate of loan payoffs and the overall persistence of lock-in in the housing market.

Unfortunately for new homebuyers, the mortgage rate lock-in effect on housing supply will continue to be a challenge. As mentioned above, if we had an immediate 2% drop in rates, the lock-in effect on home supply would still be at -13.5% through 2034. If rates stay constant, it’s -40%!

With millennials (age 28 – 43) making up the largest generation in America and at an age where they want to buy homes, this news is especially concerning. Without a major surge in supply, home prices are likely to continue to inch up.

A recent Redfin study highlights a growing affordability gap in the U.S. housing market: households now need an annual income of $113,520 to afford the median home, 35% higher than the average income of $84,072. High mortgage rates and the lock-in effect, where homeowners hesitate to sell or refinance due to less favorable rates, worsen this gap. Even though mortgage rates have dropped from their peak, if they rise again due to inflation, the required income to buy a home will also increase. Higher mortgage rates will increase the lock-in effect, which will further reduce inventory.

However, some metropolitan areas like Detroit, Michigan, offer more affordable housing, requiring just $46,168 for a median-priced home. Other cities such as Cleveland, Ohio, and Pittsburgh, Pennsylvania, also provide more accessible options, needing incomes of $58,186 and $61,603, respectively. These areas offer hope for those struggling with the nationwide affordability crisis.

The current economic indicators suggest that an immediate rate increase is unlikely. However, ongoing inflation may cause delays in anticipated rate cuts.

A delay in reducing rates could maintain current mortgage rates or cause a slight increase, impacting decisions to sell and thus influencing the housing market’s dynamics.

The market may experience stabilization, with cautious activity from buyers and sellers, awaiting clearer signals from the Federal Reserve and economic developments.