West Coast Pending Home Sales Index Down 11.8 %... Maybe Due to Increasing Mortgage Rates?

Today the National Association of REALTORS released their Pending Home Sales Index data. The data indicated a very visible cooling trend as the index was down 8.1% from the month before and down 11.8% from the year before. Having watched mortgage rates climb over the last 6 months of the year, I thought it would be interesting to show you the inverse relationship between mortgage rates and the real estate market.

This relationship is quite simple to understand: The lower the mortgage rates, the more money can be borrowed therefore pushing up home prices... as mortgage rates increase borrowers can borrower less, therefore pushing prices down.

Here is a chart I quickly prepared graphing this relationship. The Pending Home Sales Index data covers the "West" which includes California and the average 30 year mortgage rate information is directly from Freddie Mac.

Many analyst think that we need a substantial jump in mortgage rates to approximately 7.5% before there is an impact on housing prices but frankly, I always thought it was less from my 14 year experience in real estate. Especially now as the average home price is north of $500,000.

A .5% mortgage increase on a $400,000 loan increases payments by $166.00 a month... which decreases the loan amount qualified by about $28,000 assuming approximately a 6% mortgage rate.

So in the real world... a homebuyer is qualified by his mortgage lender for $500,000. This home buyer then goes out to look at homes with his REALTOR and they BEGIN their house hunting at $500,000 (although this is the maximum they are qualified for) instead of a lower amount and working their way up.

A month or two later they fall in love with a property that is $525,000 vs. the $500,000 that they were qualified for. In this time, mortgage rates went up .5%, so now the maximum they qualify for is $475,000. There is a $50,000 difference that needs to be made up, so the mortgage lender must use "creative" financing. Options like an interest only loan, stated income, or the ever popular pic-a-payment option to make up the difference (this is an entire different topic that I will touch on another time) home buyer still gets their home but they may be stretching it.

Now assume that they are unable to get this "creative" financing and now they need to look at homes in the $475,000 price range. Not fun. As now, they never find anything they like because they already looked at homes in the $525-$550 range and they must either down size (look at a smaller home or condo) or look in less expensive / desirable area. This is very frustrating for most homebuyers. So what's the usual solution... they wait to buy.

This is what I believe maybe the reason why the pending home sales are decreasing fairly dramatically and I'm sure you will soon see home prices follow suite and also start decreasing, especially if mortgage rates stay at current levels or higher and mortgage banks begin tightening mortgage underwriting guidelines.

If you have any thoughts or questions, please do not hesitate to post as your "real world" input is greatly appreciated by both other readers and me.

Data Sources: NAR & Freddie Mac.
Chart by: Jessie Beaudoin, California Real Estate Center