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The Effect of Inflation on Home Buying

Home Ownership, Housing Finances, mortgages inflation on home buying

If you’ve read the business section of any website or newspaper lately, it seems like inflation is the topic that’s on the tip of everyone’s tongue. The impact can be seen on everything from the price of soft drinks to gas. However, if you’re looking to buy a home, the impact can be bigger than it would be if you were just considering the price itself.

We’ll take a look at the effect of inflation on home buying so you can feel confident in your understanding of what’s happening in the market right now. But first, let’s make sure to start at square one.

What Is Inflation?

Inflation refers to the rate at which prices increase over time. From the point of view of a single self-interested consumer, you never want to see inflation because it means the money that you already have in your possession is worth some amount less than it was when you originally earned it. But from a macro view, some inflation is good.

In a healthy economy, there should theoretically always be some inflation. If prices tend to go up over time, it encourages people to buy goods, services and even houses now rather than waiting for some later date. This means there’s plenty of work for producers. This allows them to continue hiring people, who buy goods and services of their own.

The key is keeping a lid on inflation. You don’t want a can of soda that used to be $1.50 from the vending machine to suddenly cost a $5 bill. Another place we tend to usually see inflation show up first is the gas pump and this tends to generate headlines as well. The Federal Reserve has said its long-run goal is for inflation to be around 2% annually.

Impact of Inflation on Housing

There are two ways that housing is impacted by inflation: the price of homes themselves and mortgage interest rates.

Home Prices

As with any other item you can buy, home prices do rise with inflation. This makes sense, because the price for the materials that homes are made out of tend to go up over time. This cost is passed on by builders.

Homeowners of existing homes, if they’re behaving as rationally as any economist would expect, However, it’s worth noting that inflation isn’t the only impact on home prices and that homes do tend to experience real value increases over time due to a variety of factors. While we’ll get into some of the numbers to back up the larger trend later, let’s take a closer look at individual home price appreciation.

Home Appreciation

When a home appreciates, it’s experiencing price increases above and beyond those that would be accounted for by inflation, thereby seeing real gains in value. There are many variables that impact value increases:

  • Condition of the home: At the most basic level, you want your home to be in good shape. Otherwise, any valuation put on your home might be subject to repairs, which can delay the transaction or even kill it if repairs can’t be made within a certain timeframe.
  • Square footage: In this area, the more space you have, the higher the price relative to other homes in your area.
  • Bedrooms and bathrooms: Again, more is better. Something popular now and likely going forward is office space or extra bedrooms that could possibly be converted to offices, given that most of America was spending its time working from home during the pandemic and more workplaces may go to hybrid or fully remote work in the future.
  • Location: Society may be doing more work in their pajamas, but that’s not everybody and not all the time. Distance to workplaces and public transportation can still matter. Even if distance to an office isn’t a concern, buyers will be attracted to different things like proximity to entertainment venues, restaurants or the beach.

Interest Rates

As inflation rises, interest rates should rise with it. The goal for any investor is to earn more from the investment then they put in. In order for that to be the case, the investment has to earn at least more than the inflation rate.

Because the bonds that underlie mortgage rates offer a fixed rate of return, they aren’t as attractive to investors in an environment where prices are rising rapidly. You don’t only want to be in a 4% return on your money if inflation has risen 6% in the same time frame. Therefore, investors will pull out of bonds and put their money into things like stocks that offer a higher return in exchange for increased risk.

In response to this, bond yields rise with the hope of attracting investors again. An investor will buy in when they calculate that the return is greater than their expected rate of inflation. When the bond yields on mortgage-backed securities (MBS) rise, mortgage rates rise with them.

What’s Driving the Market Now?

Now that we know what normally impacts inflation when it comes to housing, let’s take a look at what’s happening in the market right now.

Prices Are High

In fact, in recent years, driven by low interest rates making it easier for prospective buyers to borrow more money, home prices have risen at a rate greatly outpacing inflation.

According to the most recently available Case-Shiller House Price Index data for April, home prices were up 14.9% overall on the year. Data from the Federal Housing Finance Agency puts the percentage even higher at 15.7%. There are a few reasons for this.

First, the inventory is pretty low, so supply isn’t keeping up with demand, driving the price of existing inventory up. Relative to the current pace of sales, the supply of existing homes available on the market is 2.6 months. On the new homes sales side, the number is 5.1 months. For perspective, a market is considered in balance between buyers and sellers at 6 months’ supply.

The supply problem is also not helped by the fact that people know there’s a supply problem, so rather than put their house on the market and try to move, some people are renovating their existing homes.

Although supply is better on the new homes sales side, most people want existing homes because these are historically cheaper. But with low inventory on the existing home sales side, that gap is closing. The median price of a new home was $374,400 in May. Existing home prices in June were up to a median of $363,300.

In addition to low inventory, the prices of new homes are likely to be higher. There are a couple of reasons for this. Although it’s down a little bit from recent out-of-this-world highs, they are still very high. Essentially, construction can get started faster than it’s possible to build that production in a sawmill. Moreover, it’s been recently impacted by wildfires.

Finally, whether because of fears of COVID-19 or a lack of a job match between the labor force and employers, many industries have had trouble finding labor. Construction has been no exception. Higher wages lead to higher construction costs, which can lead to higher prices for new homes.

Interest Rates Could Rise

Overall inflation has suddenly risen 5.4% in the last year, according to June numbers from the Bureau of Labor Statistics. That’s the fastest pace since August 2008. The Federal Reserve is on record as saying it believes the inflation is transitory, the result of demand skyrocketing now that we’re in the latter stages of the pandemic, while kinks in the supply chain haven’t been worked out yet, causing demand to outpace supply.

However, if inflation were to keep up at this pace, the Fed would eventually have to act to push up the federal funds rate in order to try to tamp down inflation. If they do that, interest rates would eventually move up all of the economy, including for mortgages.

Rates are still extremely low for now. Data from recent surveys from the mortgage investor Freddie Mac have shared 30-year fixed rates in the high 2% range, but no one knows how long it will stay that way. If you’re financially prepared, now is a really good time to buy.

It’s also worth noting that interest rates are somewhat lower right now because the Fed is buying $40 billion worth of agency MBS per month. Although the Fed has telegraphed that there will be plenty of warning before changes are made to the current policy, because there is more demand in the mortgage bond market, rates can be lower and still attract a buyer. If the Fed exits the market, rates would certainly go up unless other buyers picked up the slack.

How Inflation Could Impact Home Buying

Although it might make sense that in the short term, inflation would drive home prices up, if you take a longer view, prices might level off or even dip slightly when the Federal Reserve raises short-term interest rates and longer-term rates follow suit. Depending on where you look, some data sources seem to suggest this is already happening. What’s the reasoning?

Simply put, it’s a pretty good bet that prices are high in part because sellers know that borrowers have more buying power given low interest rates. When they go up a little bit, that buying power goes down and eventually sellers will have to lower their expectations a bit and prices may even come down.

How Buyers Should React to This Market

If you’re thinking about buying in today’s market, you’ll want to take the following tips into account.

Pay Down Existing Debts

Debt-to-income ratio (DTI) is one of the key qualification factors in the eyes of a lender. Essentially, it looks at the amount of your existing installment and revolving monthly debt payments compared to your monthly gross income. The lower this percentage is, the better. It means you can afford a higher monthly payment, which could allow you to pay more for a home. This could be key in a competitive market.

You also don’t want to make any new purchases on credit or open any new accounts because this could increase your DTI and cause problems for you during the mortgage process.

Although some mortgage types will let you qualify with a higher DTI, it’s generally recommended to keep your DTI at or below 43% in order to qualify for the most loan options. Paying down your debt and keeping it in check could help give you more room in your budget.

Also, regardless of DTI, it’s generally not advised to spend up to the top end of your budget. If you do, one income shock or unexpected medical bill could put you in financial trouble. You also don’t want to be house poor. Being a little more conservative with house offers can help you accomplish other financial goals, establish an emergency fund and have money left over for vacations, for example.

Get Credit Ready

Paying down debts ties in well to this next section because doing that will help raise your credit score. In addition to needing a minimum credit score to qualify for most loans, the higher your score, the better your rate.

Along with paying down debts, you’ll want to take care of any negative credit items like collections and charge-offs if possible before applying. This will raise your score.

Of course, in order to do this, you’ll need to know about them. You can get your credit report annually from each of the three credit bureaus to help avoid surprises. Right now, you can access these reports weekly as an added measure of awareness during the pandemic

Be Realistic

With home prices being what they are, you may not be able to get everything you want in your budget range, so it’s important to do a couple things. Determine if there’s anything in your budget that you’re paying for that you’re not really getting any value out of and cut it. Leave only what you need and what you get the most utility from in terms of extras.

Secondly, when it comes to the house, determine the things you absolutely need, followed by the things you most want and then what you can live without. This will help you not go crazy in a bidding war for a house and go beyond your budget.

Save As Much As You Can

The good news is you can get a conventional loan on a one-unit primary property with as little as 3% down. However, depending on what home prices are like in your area, that can still be a significant chunk of change. Moreover, if you can put down the bigger down payment, it can really pay off to do so. In addition to your credit score, your down payment is the other huge factor impacting your rate.

Basically, the less a lender has to give you, the less risk there is involved in doing the loan, hence the lower rate. Alternatively, you can buy down the interest rate by paying at closing for discount points, which is prepaid interest. One point is equal to 1% of the loan amount. Typically, when lenders advertise rates, those are tied to a point value.

You also have to factor in other closing costs. In addition to discount points, this can include things like title work and recording fees, appraisals, prepaid homeowners insurance premiums and escrow/impound account setup. This can total 3% – 6% of the purchase price.

You can negotiate with lenders for lower closing costs through a lender credit, but be aware that this usually comes in exchange for a slightly higher rate. The more you can save in advance, the better.

Lenders also have different costs, so it’s important to shop around and compare the annual percentage rate (APR) shown on each the loan estimates. Some of these fees may also be negotiable as lenders want your business. The bigger the difference between the interest rate on which your payment is based and the APR, the more you’re being charged in closing costs. You’ll want to get estimates from a few different lenders.

Now that you know what to expect, it’s time to get ready. Let’s help you save for a house.

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