Interest Rates and the Housing Market: What’s Next?

25th November 2022

As interest rates rise, how will the housing market respond? This article explores the challenges and opportunities in the property market in light of potential rate hikes

The housing market has long been a cornerstone of economic discourse. From the bustling real estate exchanges in major cities to the sleepy suburban developments, the ebb and flow of property values can often serve as a barometer for the health of the broader economy. In 2022, as the world emerges from the pandemic and begins to grapple with inflationary pressures, the question that looms large is: How will rising interest rates impact the housing market?

Interest rates are among the most potent tools in a central bank’s arsenal. When rates rise, borrowing becomes more expensive, and when they fall, borrowing becomes cheaper. This simple dynamic forms the basis of much of the economic activity in the housing sector. The key question for the future, however, is whether the rise in interest rates will cool the housing market or spur a new wave of challenges for homebuyers and investors.

To begin with, let’s first consider the backdrop against which these rate hikes are occurring. Throughout much of 2020 and 2021, central banks around the world slashed interest rates to historic lows in a bid to mitigate the economic fallout from the COVID-19 pandemic. This policy, while effective in stimulating economic activity in the short term, also had unintended consequences—none more pronounced than the soaring demand in housing markets across many advanced economies. With borrowing costs at record lows, homebuyers found themselves able to purchase properties at higher price points, leading to bidding wars, increased house prices, and an overheated market.

Now, as the pandemic’s most acute phases appear to be over, inflation has emerged as the key economic concern. In an attempt to rein in rising prices, central banks—led by the US Federal Reserve and the European Central Bank—have signalled a shift towards tightening monetary policy. The prospect of interest rate hikes has already begun to make waves in the housing market, with many economists predicting that higher rates could bring an end to the extraordinary price increases seen in recent years.

For potential homebuyers, rising interest rates represent both a challenge and an opportunity. On the one hand, higher rates mean that monthly mortgage payments will rise, making it more difficult for many to afford new homes. This is especially true for first-time buyers, who often rely on affordable borrowing to enter the market. With rates climbing, many potential buyers may find themselves priced out of the market or forced to scale back their purchasing plans. The rise in mortgage rates could also discourage some people from moving to larger homes, leading to a cooling in housing demand overall.

However, for those already established in the housing market with fixed-rate mortgages, higher interest rates may not have an immediate impact. Homeowners with long-term loans will continue to pay their original rates, even as new buyers face higher borrowing costs. For these individuals, the impact of rising rates will likely be felt when they eventually look to move or refinance their properties. As the cost of borrowing increases, the pool of potential buyers for their homes could shrink, potentially making it more difficult to sell.

From the perspective of investors, the rise in interest rates could create both risks and opportunities. On the one hand, higher rates often signal an attempt by central banks to curb inflation, which can be a sign of a more stable economic environment in the long run. Investors who are able to weather the short-term fluctuations may find that the housing market stabilises, presenting new opportunities for property acquisitions. Additionally, higher interest rates may cause a revaluation of real estate assets, as investors adjust their expectations of future returns.

On the other hand, rising rates could also make real estate investments less attractive, particularly for those relying on leverage to finance their purchases. Higher borrowing costs could mean that the returns on real estate investments no longer justify the risk, leading to a pullback from the market. For investors who have overleveraged themselves during the low-rate environment, rising interest rates could increase the risk of defaults and forced sales, which could further depress property prices.

The question of whether the housing market will experience a slowdown or merely a shift in dynamics depends on several factors. Central banks, for their part, are likely to proceed cautiously in raising interest rates, aware of the delicate balance they must strike between controlling inflation and avoiding an economic slowdown. While higher rates are certainly a tool in curbing inflationary pressures, they are not without their costs. If the central banks raise rates too quickly or too aggressively, there is a risk of stalling economic growth and potentially triggering a recession.

One of the key challenges in forecasting the housing market’s response to rising interest rates is the uncertainty surrounding the broader economy. While inflation is the primary concern, other factors, such as geopolitical tensions, supply chain disruptions, and labour shortages, also weigh heavily on the economic outlook. These factors, in turn, can influence the housing market in unpredictable ways.

In literature, the relationship between risk and reward has been explored in many different contexts.

One such example is the tale of Dr. Jekyll and Mr. Hyde by Robert Louis Stevenson, where the protagonist’s desire to transcend his moral boundaries leads him into a dangerous and uncontrollable path. Just as Dr. Jekyll’s experiments go awry, so too can economic policies go wrong when the balance between risk and reward is not properly managed. In this case, the decision to raise interest rates in an attempt to curb inflation could have unintended consequences for the housing market, much like Jekyll’s attempts to control the darker side of his nature. If the balance is tipped too far in one direction, the resulting consequences could be severe.

The classic novel The Great Gatsby by F. Scott Fitzgerald offers another metaphorical lens through which to view the housing market’s response to interest rate hikes. Gatsby’s lavish parties and pursuit of the American Dream represent the allure of prosperity and excess. In much the same way, the housing market’s soaring prices over the past few years have been driven by the dream of homeownership and financial success. But just as Gatsby’s world crumbles under the weight of his illusions, the housing market too may face a rude awakening if rising interest rates deflate the bubble of excessive valuations.

In conclusion, the rise in interest rates experienced in 2022 represents a critical turning point for the housing market. The impact of these rate hikes will depend on the broader economic context, as well as the actions taken by central banks and policymakers. While the immediate effect may be a slowdown in demand as borrowing costs rise, the long-term effects are still uncertain. For homebuyers, investors, and policymakers alike, the key challenge will be navigating the delicate balance between maintaining economic stability and fostering sustainable growth in the housing market. The metaphorical lessons found in literature, from Dr. Jekyll and Mr. Hyde to The Great Gatsby, serve as reminders of the fragility of dreams and the risks of unchecked ambition—lessons that may well resonate in the coming months as the housing market responds to the evolving economic landscape.