San Diego Housing Market News and Analysis
Interest Rates, Inflation and Home Prices
User Forum Topic
Submitted by XBoxBoy on May 28, 2021 - 9:57am
I've been thinking about the question of how much recent price rises are due to work from home narratives, people moving from other areas, and how much is due to record low interest rates. To answer this, I decided to make some charts that would show what I could reasonably expect to happen when interest rates change.
This first graph shows the relationship between interest rates and the size of a loan with a set monthly payment. To create this graph I used $2,500 a month payment. (Which might seem low for San Diego, but the amount of the monthly payment isn't important, a larger payment simply moves the graph up.) I did not include taxes or mortgage insurance, or consider down payment. All examples I'm using are for 30 yr. fixed. The goal here is to just show how much more you can afford as rates change.
Two simple take-aways from this chart: 1) The obvious, that as interest rates go down you can afford a lot higher purchase price and 2) as interest rates go down the curve gets steeper and so prices increase more due to a .5 percent drop from 3 to 2.5 than from a .5 percent drop from 8 to 7.5.
Next, I wanted to add some historical perspective to this. Interest rates have changed a lot over the years, so how much of the change in home prices is due to change in interest rates? Here's a graph that shows, given a monthly payment combined with the 30 yr. rate at a given time, what would be the purchase price you could afford. (Again, ignoring taxes, insurance, & down payment)
For this chart, I'm using a monthly payment of $2500, a starting date of January 1987 and mortgage rate data from FRED. I am not taking into account points paid. I'm not sure how important that is or isn't.
Now, the problem with the previous chart is that it assumes that over time the monthly payment people could afford wouldn't change. But over time inflation should cause wages to increase, thus increasing what people feel they can pay monthly. So, I've added a bit of code that increases the monthly payment by the inflation rate. Here's the chart with a starting monthly payment of $2500 and every month I adjust that amount for inflation.
Note the above does not deal with the issue of location at all. The above merely looks at the impacts of interest rate changes and inflation on expected home price. These charts are not unique to San Diego, or any sub-area.(Which brings up a bunch of interesting questions about what has happened in areas where home prices haven't risen over the years!)
But now, let's introduce some data to see how the expected home price compares to actual home prices. To do this, we can use the Case Shiller Index. I'll calculate the initial price based on what could be afforded on January 1, 1987 and then using San Diego Case Shiller Index, plot the Case Shiller price over the years.
In the above chart you can clearly see the housing bubble of the early 2000's! (And note, the above chart uses San Diego Case Shiller, not national Case Shiller)
One last point, the above charts are all linear in both the x and y. But arguably the y (price) should be shown as a log scale. So here's the final chart showing my interest rate and inflation adjusted expected price and the Case Shiller price with a log scale for the y.
So what to make of the above charts? First I think it'll be really interesting to see how different people will interpret the charts differently and to see how people use the charts to argue differing points.
But for me, the biggest observation is that most if not all of the home price increases we've seen in San Diego are the result of interest rate changes and inflation. This isn't a commonly held view, and one I would have doubted before doing these charts. The narrative that the home prices increases over the years are because so many people want to move here and that demand has grown while supply of houses hasn't, just doesn't hold up when I look at these charts.
The other thing is, if home prices increases are so strongly correlated to interest rates and inflation, what would happen if interest rates were to start rising? I'm not saying that's going to happen but it's worth keeping an eye on.
Sources of data:
Case Shiller San Diego:
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