By Greg Ninness
A 1% rise in mortgage interest rates could force house prices down by almost 10%. A 2% rise in mortgage interest rates could force house prices down by almost 18%.
This is why rising interest rates are likely to have a much bigger impact on housing affordability than the changes to the tax treatment of residential investment properties recently announced by the Government.
Most of the discussion around the effect of rising mortgage interest rates usually focusses on the resulting increase in mortgage payments and the ability of borrowers to make those higher payments, plus the flow on effects that has on other household spending and the wider economy.
What is often overlooked is that rising interest rates also affect the amount people can afford to borrow, and that has a fundamental impact on house prices because it directly affects how much they can afford to pay for a home.
Let's say the most someone could afford to borrow to buy a home was $500,000.
If the mortgage was for 80% of the purchase price, the most they could afford to pay for a home would be $625,000.
The payments on a $500,000 mortgage at the average of the two year fixed rates charged by the major banks in May 2021 (2.52%) would be $914 a fortnight, assuming a 30-year term.
If mortgage interest rates increased by 100 basis points (that's a 1% increase in ordinary parlance) to 3.52%, the maximum amount the home buyer could borrow and maintain mortgage payments at the same level would be $440,000, a reduction of $60,000.
Assuming the amount they had for a deposit remained the same, it would reduce the maximum amount they could afford to pay for a home to $565,000, down by 9.6%.
If mortgage interest rates increased by 200 basis points (up 2%) to 4.52%, that would reduce the maximum amount the house buyer could borrow by $110,000 and the amount they could afford to pay for a home to $515,000, a decline of 17.6%.
Those percentage figures hold true for all price brackets.
So someone who could afford to borrow a maximum of $700,000 to buy a home for $875,000 at current interest rates, would only be able to afford a $791,000 home if mortgage rates went up by 1%, or a $721,000 home if mortgage rates went up by 2%.
If the maximum they could afford to borrow was $900,000 to buy a home for $1,125,000 at current rates, a 1% increase would reduce the amount they could afford to pay for a home to $1,017,100. A 2% increase would reduce the amount they could afford to pay to $927,000.
Those are significant reductions and they suggest rising interest rates have the potential to cause a reasonably substantial reduction in house prices.
Interest.co.nz has been recording the monthly averages of the two year fixed mortgage rates offered by major banks since the beginning of 2002. The last time they were at 3.52% was in February 2020, while the last time they were at 4.52% was March 2018.
So mortgage rate increases of 1% to 2% are not unrealistic.
The peak since 2002 was a lofty 9.64%, achieved in March 2008.
However it’s important to note that the calculations above are for people borrowing the maximum amount they are able to. Typically they are more likely to be first home buyers.
Those people who already have a home but are looking to move up the property ladder would probably have a bit more wriggle room to cope with rising mortgage rates and may not be as severely affected as those buying their first home, although their borrowing capacity would also likely be crimped to some degree.
So the reductions outlined above should be regarded as “up to” figures, i.e, a 1% rise in mortgage rates could cause house prices to decline by up to 9.6%, while and 2% increase could cause them to decline by up to 17.6%.
And the fall in prices could be greater at the bottom end of the market than the top.
On top of that the market will continue to be affected by changes in household incomes, the balance of supply and demand for housing and the general performance of the economy.
So what effect rising interest rates end up actually having on house prices will have to come out in the wash.
But there’s certainly potential for the impact to be significant.
The comment stream on this story is now closed.
*This article was first published in our email for paying subscribers. See here for more details and how to subscribe.