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Home affordability has crumbled this year, and it may erode further at the hands of the Federal Reserve.
The Fed on Wednesday raised the federal funds rate by three-quarters of a percentage point to a range of 3.75% to 4%. The central bank's action will directly or indirectly raise the floor under several consumer interest rates, including those for home equity lines of credit and mortgages.
This year, the Fed has increased the federal funds rate by 3.75 percentage points. Meanwhile, the average rate on the 30-year fixed-rate mortgage has risen by a similar amount. The Fed rate is expected to increase again in mid-December, and that prospect could push mortgage rates higher in the meantime.
Fed policy has bashed home affordability
The 30-year mortgage rate surpassed 7% in October, marking the fastest rise in mortgage rates in 41 years — and making it more expensive to pay for a home.
Consider a home buyer who can afford $1,800 a month in mortgage principal and interest payments.
In January, with a 3.25% interest rate, the buyer could afford to borrow $413,600.
In October, with a 7% interest rate, the same buyer could afford to borrow $270,600. The higher interest rate subtracted $143,000 from the buyer's borrowing capacity.
Making things even harder for buyers, home prices were higher in the fall than at the beginning of the year. The median home resale price was $354,300 in January and $384,800 in September, according to the National Association of Realtors.
The number of households that could afford a $400,000 mortgage shrank by 24 million when mortgage rates rose from 3% to 7% in the past year, tweeted Eric Finnigan, vice president of research and demographics for John Burns Real Estate Consulting.
Now that fewer people can afford houses, sales are declining. The annualized pace of existing home sales plunged more than 20% in July compared with a year before, according to the National Association of Realtors. The year-over-year sales pace declined even more in August and September.
The drop in demand has caused home prices to slip since peaking in June. According to the Federal Housing Finance Agency, house prices declined 0.6% in July compared with the previous month and fell 0.7% in August. It was the first time that prices had fallen two months in a row since February and March 2011, an FHFA economist said.
Fed intends a 'difficult correction'
So far, skyrocketing mortgage rates have overwhelmed modest drops in prices, and the Fed intends to lower home prices further by making mortgages more expensive. At some point, this policy is supposed to result in greater overall affordability.
That would take a substantial drop in prices, which in Fedspeak is called a correction. The Fed hasn't defined how much of a price decline counts as a correction.
In a news conference after the central bank's September meeting, Fed Chair Jerome Powell said the goal is to get to a point at which "people can afford houses again. And I think we — so we probably, in the housing market, have to go through a correction to get back to that place."
Powell said a "difficult correction," not a mild one, is necessary to "put the housing market back into better balance."
High interest rates may last for years
At this point in the Fed's rate-raising cycle, no one is coming out ahead. Would-be home buyers might welcome falling house prices but not rising mortgage rates. Homeowners and home sellers don't enjoy watching their home values decline.
"The housing market is likely to be the bystander victim in the Federal Reserve's fight on inflation," Jaime Peters, assistant professor of finance for Maryville University, said in an email. "The Fed’s moves have already put a damper on the once-hot housing market, but housing is only one front of a bigger war. Inflation in food, finished goods, services and energy continue despite the Federal Reserve’s moves to date. The Federal Reserve is going to continue raising rates to fight all those other fronts — and housing is going to suffer."
The suffering may persist for at least a couple of years. In the Fed's September summary of economic projections, policymakers predicted that the federal funds rate will be higher in 2023. There's scant consensus on how much it will fall — if at all — in 2024. Most predict that it will be 1 or 2 percentage points lower in 2025.
Mortgage rates might accompany that downward drift in 2024 or 2025 — but don't count on them falling next year. And when they do drop, they are unlikely to go down as quickly as they went up this year.
If the Fed nudges interest rates lower in 2024 or 2025 and if home prices go through a correction but not a crash, we might see homes become more affordable and buyers and sellers achieve roughly equal negotiating power. That's a lot of ifs, but it's what the Fed is aiming for.
How to make homebuying less painful
Meanwhile, people will still buy and sell houses as they marry, divorce, have children, adopt dogs, move for better jobs, get away from rising seas or smoky air and retire. A few strategies can ease the financial pain.
"Most home buyers look at affordability based on monthly mortgage payments, not total home price," Peters said. "So, as interest rates rise, a homebuyer won’t be 'priced out of the market' immediately, but instead may need to settle for a smaller or older home with a lower price tag to keep the monthly mortgage payment in an affordable territory."
When buyers find homes they can afford, they have a couple of ways to push the monthly payments lower, at least temporarily:
Get an adjustable-rate mortgage. The popular 5-year ARM starts with an interest rate that's lower than the rate available on a 30-year fixed-rate mortgage. The rate can go up or down after five years.
Ask the seller or home builder to pay for a temporary buydown, which reduces the buyer's monthly payments for the first one to three years. Temporary buydowns were popular when interest rates were sky-high in the early 1980s, and those tactics are coming back. (The 30-year rate lingered in the double digits from November 1978 to March 1986, topping out at 18.63% in October 1981, according to Freddie Mac.)
November mortgage rates forecast
Mortgage rates have been rising steadily since August, and there's little reason for them to reverse course in November. Inflation continues to run higher than the Fed wants, and the central bank will almost surely raise the federal funds rate again in mid-December. Both factors — inflation and the Fed's rate-raising campaign to quell inflation — should push mortgage rates upward in November.
What happened to mortgage rates in October
Rates reached a milestone in October: The average rate on the 30-year fixed-rate mortgage surpassed 7% for the first time since April 2002. Rates on the 15-year fixed-rate mortgage and the 5-year ARM went up, too.
Interest rates tend to be higher when inflation is high, and the link between rising prices and mortgage rates was evident in October. Inflation remained elevated, with the September Consumer Price Index showing that prices had risen 8.2% over the previous 12 months. It was virtually the same as the August reading, dashing hopes that the inflation rate would improve.
At the beginning of October, NerdWallet predicted that mortgage rates were "likely to keep on rising in October." That's what happened, as the average rate on the 30-year mortgage went up week by week.