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The Downside of Up: How Rising Mortgage Rates Will Lead to Lower Sales

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For 30 years, falling mortgage interest rates have enabled homeowners to move into ever-larger homes on the promise of ever-cheaper financing. But that party is over, and the impact on existing home sales could be significant.

After peaking at more than 18 percent in 1981, rates on a 30-year, fixed mortgage fell steadily, bottoming at 3.3 percent in late 2012, according to Freddie Mac. Rates then jumped into the mid-4 percent range before retreating more recently. Nobody expects rates in the teens again, but rates in the 5 percent and 6 percent range are no longer out of sight.

Housing was relatively simple as rates fell. When I first bought a home, I had a mortgage rate of about 8 percent. A few years later, when I re-entered the market, I qualified for a rate of about 5 percent. With this lower rate, I had a choice: I could buy a more expensive and larger home, but still pay roughly the same amount per month thanks to lower financing costs. Or I could buy a similarly priced home to the one I was currently in, and lower my monthly payment and pocket the savings.

And I wasn't alone. Today's currently very low rates are helping to boost existing home sales volume by roughly 15 percent, according to Zillow research. This effect has acted as a tailwind for decades, helping millions of homeowners move up the chain to bigger, more expensive homes.

But as rates rise, the script flips. Higher rates will discourage or disqualify some potential future buyers that may have otherwise entered the market when rates were lower. And thanks to a furious refinancing push by lenders and a sense that low interest rates couldn't last forever, millions of current homeowners are now locked in at mortgage rates close to or at historic lows.

It remains to be seen whether homeowners locked in at today's low rates will be willing or able to buy again later when rates could be almost double what they were even a year ago. Instead of paying the same amount each month for a larger home, some homeowners may be faced with the prospect of paying more per month for a home very similar to the one they're already in. This is the phenomenon referred to as "mortgage rate lock."

The Mortgage Bankers Association is currently predicting that rates on a 30-year, fixed rate mortgage will rise to 5.1 percent by mid-2015. If that happens, then mortgage rate lock will become a pronounced headwind for the housing market, reducing home sales by about 4 percent from current levels even after accounting for positive factors like modestly higher incomes and more households.

Still, many discount this problem, thinking that we will continue to enjoy very low rates for years to come. Admittedly, this doesn't seem too far-fetched given the most recent data. But even in this more benign scenario, the simple fact that rates aren't still falling will begin to create a drag on home sales as soon as autumn 2015 (representing 100,000 fewer sales by then, all other things being equal). This drag will have to be offset by higher than normal rates of income growth or much higher homeownership rates, neither of which seems very likely by that time.

The bottom line is this: For a generation, we've gotten used to falling mortgage rates and the boost they had on sales. Very low rates in recent years have done the heavy lifting we wanted them to do, namely helping to boost home sales from the depths of the recession. But whether rates rise quickly or not, it's safe to say that they won't continue falling over the long-term as they have for the past 30 years.

And as is always the case, there's no free lunch. We're about to get the check, not just for the recent very low rates, but for the 30-year-long buffet in which we've feasted on falling rates.

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