Interest Rates Effect on Housing Prices

by Mike Holman


We’re obviously coming off of a period of very low interest rates. When rates were low, I thought to myself “now is a great time to buy a house, since I can get a great rate on my mortgage”. Amusingly, the truth of this statement made it incorrect.

When interest rates are low, you aren’t the only one who notices. Many people decide its time to buy their first property (or upgrade to a larger property), and consequently prices get driven up: supply and demand. When interest rates are high, no one wants to buy. This causes people who HAVE to sell to either give a super deal, or to provide vendor financing at a more reasonable interest rate, which is itself a super deal.

Much as buying stocks when the market is down makes sense, often buying real estate when interest rates are high makes sense for similar reasons. With the stock market, the masses have been scared off, so you don’t have competition. Similarly with real estate. Bidding wars happen when lots of people can afford to buy.

In theory the best approach might be to buy when interest rates are high, get a variable mortgage, then when you renew if rates are lower, borrow as much as you can and get a fixed rate. If you’re renewing when rates are high, obviously get another variable rate mortage. Supposedly the long-term average interest rate in Canada is around 10%, so you can use that to decide when rates are high or low. Personally I like fixed-interest mortgages, just because it helps me plan my cash flow better. I realize I’m supposedly paying more for this, but as far as insurance goes I feel like its pretty cheap. If my mortgage was above 10%, there’s no way I would consider a fixed-rate mortgage (variable would be totally the way to go at that point).

You could also try to sell when interest rates are low, since that’s probably when there will be the most buyers available and you should get the best price.

If you can afford a big down-payment during high interest periods, not only would putting the money into your property be a good idea (since high interest periods also have high inflation and real estate is a great inflation hedge), but since you’d have a smaller mortgage, you won’t be paying as much at the super-high interest rate. Alternatively you could make the case that a big mortgage is still worthwhile, since you can benefit from the inflation (and if you have a variable mortgage, you’ll get immediate advantage when rates drop). Obviously don’t buy more house than you can afford!

You still need to be a savvy buyer and negotiate hard. Paying a higher rate due to mortgage insurance or long amortization isn’t all that helpful (this is an expensive way to purchase a house for people who don’t have any other options). If you pay top dollar for a property in a high-interest environment, the results won’t be pretty (although the seller will probably be laughing all theł way to the bank).

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{ 4 comments… read them below or add one }

1 jesse

There is some relationship between interest rates and higher prices but any look at the US shows that the effects are second order compared to good old supply and demand. As for buying in cash when interest rates are higher, well, when interest rates are high it’s because other investments are returning high rates too. It’s quite the leap to invest in property during higher interest rate conditions. Any look back to around 1998-2000 when interest rates were higher (and important to note, inflation was low even though rates were high) shows that other investments of similar risk were pulling in 7-8% easy. You would have to forgo the spread between property and these other investments in the name of higher future returns and know that was going to happen. Not as easy as it sounds.

I have doubts we will see markedly higher rates in the near future. It would require a purging of the latest financial crisis losers much faster than what is currently happening. Still, Japan is an example of where property prices can fall despite low mortgage rates.

2 Mr. Cheap

jesse: it was quite a while ago when I wrote this (August 2007), and like yourself, I don’t agree with it. The central thesis in this post (which I do still agree with) was that low interest rates leads to more buyers which leads to increased demand which leads to higher prices, all other things being equal. I definitely overstated the correlation (as you say, a number of other factors can come into play) and I agree with you that this would be a naive metric to guide an investment strategy.

3 Four Pillars

I think this strategy is valid for extreme interest rates.

Under “normal” circumstances, if rates go a bit above or below the long term averages then Jess is right – other investments will also change to reduce the effect. Also as far as affordability (which affects demand) – if the interest rates are higher (let’s say 10%) than the longer term average (let’s say 7%) then the interest costs are higher which will reduce demand, but they are not dramatically higher so the demand should still be there. If the rates jump up to 16% then the interest costs are SO much higher that demand will drop – probably to near zero. At this point I think you can get a “deal”.

Same thing if rates are lower. If the rates are say 5% then that makes houses more affordable than the normal 7% but again, not enough to increase demand is a huge way. If the rates drop to 2.5% then this makes such a huge difference in affordability that the demand skyrockets because the number of people who can afford a house (assuming prices stay the same) has increased by a huge amount.

In mathematical terms my theory says that demand for housing is directly related to interest rates (among other things) but not in a linear fashion when interest rates are at extreme values. If there are N people in the housing market when rates are at 10% then there might be 3N people in the market when rates are at 5%. If rates go down to 2% then there might be 10N people looking to buy.

Of course factors like unemployment rates, the economy etc are important but I think when interest rates are at extreme values, then that will over shadow all other factors.

4 jesse

Low interest rates do have an effect empirically. They have an effect because people are effectively capitalizing a multi-decades investment based upon relatively short-term financing lengths. For a utility company, and apparently a few Bay Street economists as of late, this would seem a rather odd behavior.

Why is this? One reason is that people are expecting income gains faster than inflation as they age. In other words they can absorb higher rates in the future. The flaw is that nobody asks who would be buying when they want to sell. Another reason is that people are assuming low rates are here to stay. If they are, unfortunately, it means deflation.

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