Is the Housing Sector Doomed Once Interest Rates Start Rising?

By Markets Fool.com

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Source: flickr user Mark Moz

Most experts and analysts expect the Federal Reserve to start raising interest rates later this year, so how could it affect the housing sector? Sure, mortgage rates will go up with the Fed funds rate, but this doesn't exactly tell the whole story. We asked three of our analysts to give their predictions about what rising rates could mean to housing. Here's what they had to say:

Matt Frankel:I don't believe the real estate market is doomed once interest rates start to rise again. Although even a marginally higher interest rate makes a significant difference over the life of a loan, mortgage payments on a monthly basis won't get that much more expensive when rates begin to rise -- at least at first.

Let's say you want to buy a house and will take out a $200,000 mortgage. With today's average 30-year mortgage rate of about 3.9%, this would produce a monthly payment of $943. If rates were to increase 0.5% before the end of 2015, it would increase the payment to around $1,000. So while it would be a little more expensive, it won't make buying a home unaffordable. Of course, if rates were to spike by, say, three or four full percentage points, it could be a different story, but that's a highly unlikely scenario.

Interest rate fluctuations are a normal part of a healthy housing market and shouldn't be feared. In fact, a rate increase is a good indicator that the housing market and overall economy are improving.

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Jordan Wathen: I don't think rising rates will doom the housing sector either, but I think it will have two broad impacts that will be measurable and noticeable.

First, given that most Americans purchase homes with fixed-rate mortgages, those who have a fixed-rate mortgage will be less inclined to move. The simple reality is that homeowners have the option to keep their mortgage rate by staying in the same home. If you locked in your rate at 4%, moving into a new home and financing it at, say, 6%, is much less attractive.

Second, I think rising mortgage rates will have the largest impact on the most expensive homes on the market. Whereas almost any qualified homebuyer can purchase a "starter home," not everyone can afford a three- or four-bedroom McMansion in the suburbs. As rates rise, the monthly cost of servicing a mortgage on higher-end homes will push marginal buyers out of the market.

In all, I don't expect rising rates to be a death knell for real estate. Rising rates will keep inventory off the market as it becomes less attractive to move, just as rising rates will push marginal homebuyers out of the market for a home. If anything, household formation, not rising rates, will have the biggest impact on real estate going forward. And household formation has been climbing ever since the depth of the recession in 2009, a trend that probably won't stop in its tracks from a small move in interest rates.

Dan Caplinger: Jordan and Matt make smart arguments for how the housing market could sustain higher rates, but I still think the housing sector will have a lot of problems once rates rise. One thing to remember is that homebuilders have also enjoyed the fruits of low rates, as they've been able to finance land purchases cheaply, giving them more latitude to develop new properties. If debt gets more expensive, they'll have to be more selective about which projects they take on, and that could hurt their share prices.

In addition, although Matt's numbers about typical mortgages are correct, they underestimate the impact of even small rate changes in expensive markets where typical mortgage loans are much higher. There, even minimal changes can price out the marginal borrower. Also, rising rates can prevent those who would otherwise choose more efficient options such as 15-year mortgages to have to resort to more traditional 30-year mortgage financing, leaving them with longer periods to repay their debt.

It's true that because we haven't seen as much excess in the housing market during this cyclical upturn, the downturn won't be as severe as the housing crisis was in 2007 and 2008. Yet rising rates won't do homeowners any favors, even if they're inevitable from a market standpoint.

The article Is the Housing Sector Doomed Once Interest Rates Start Rising? originally appeared on Fool.com.

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