Will home prices continue to rise in the face of higher mortgage rates, or are they destined to fall? The answer is yes.

There seems to be a lot of uncertainty regarding home prices. On one hand, households are getting hammered by the worst inflation in generations, we've had an explosion in home price appreciation that makes affordability a real problem, and mortgage rates are shooting up. On the other hand, we still have an inventory problem that is the result of the lack of homebuilding to any serious degree in the years following the Great Recession.

After careful analysis of Freddie Mac's Primary Mortgage Market Survey data, combined with median home sales prices data from the St. Louis Federal Reserve, I can confidently tell you that there is either an incredibly strong correlation between mortgage rates and home prices, or none at all.

While this may not appear to be helpful in the slightest, please allow me to explain. Also, please note that I'm keeping things at an aggregate national level.

If you look at the history of mortgage rates compared to home prices, it appears that from the 1970s until the Great Recession, we have some incredibly wild swings in mortgage rates combined with a rather steady national home price appreciation trend.

Sure, one can make the argument that from the early 1980s onwards, rate and home prices have a strong correlation, but it's pretty hard to swat away the lack of a decline in home prices as mortgage rates reached astronomical levels in the 1970s.

Now, mortgage rates have a pretty powerful impact on your monthly payment, so let's examine the relationship between historical rates, and an estimated payment. The payment estimation reflects the P&I of a 30 year, 80% LTV mortgage on the median home prices from the graph above.

As expected, payment does seem to track well with interest rates, until you get to the mid 1980s into mid 1990s and then there's a divergence. Could this be somehow related to the change in how capital gains were taxed on homes, or perhaps the Tax Reform Act of 1986? It's an interesting question, and I'd certainly love to see some research around it. Regardless, one thing we do know is that a lower rate should result in a lower payment, unless the decrease in rates isn't enough to overcome the increase in the amount being financed.

So what have we learned so far? Home prices don't appear to track well with mortgage rates, and mortgage payments don't even appear to track mortgage rates based upon observed history. I'll admit, even I'm skeptical of myself at this point, but let's soldier on and look at the relationship between home price and estimated mortgage payment.

Looking at the graph, the relationship between home prices and estimated payments starts to really form nicely in the 2000s, and is amazingly strong from the Great Recession onwards. Prior to the 2000s, it really appears as if the volatility of mortgage payments doesn't really translate into nearly as much volatility in home prices.

So what does this all mean? It means that historically, we can't really seem to triangulate what will happen with home prices based upon interest rates and the corresponding mortgage payment. If we look back in history, we'd have no basis to conclude that rising rates will put a damper on home prices, but at the same time, it appears like recent history is showing a pretty strong correlation between payments and prices.

Let's step back for a second and consider incomes and expenditures. If it suddenly becomes $200 a month more expensive to buy a home, absent an increase in income, people are left with three choices: 1) reduce their consumption of goods and services to the tune of $200 per month; 2) decrease their savings by $200 per month; 3) settle for less house, which for some means being a renter. Of course, you can do a mixture of all three, but at the end of the day, absent an increase in household income, something has to give. I'd also note that I'd lump wealth depletion or going into debt in with a decrease in savings that results in a negative savings rate.

So home prices may have to come down, or they may not, and it all depends on the decisions that individual households make in terms of the expenditure patterns.

My theory, based on observing how our society has changed leads me to one conclusion: people love it when their home increases in value, and they pay attention to home prices when it comes to the wealth effect (you're wealthier, so you'll now spend more), but when it comes to purchasing a home, people are payment buyers.

When it comes to buying a house, you need a downpayment. If you check out the Urban Institute's "Housing Finance at a Glance" monthly chart book, it'll confirm that down payments are shrinking. Is that because it's harder to save that downpayment, or is it because borrowers view it as a smart move to buy a house as quickly as possible, even if it means increased borrowing costs due to mortgage insurance and LLPAs? Both of these things are probably true. The result is that the borrower has more leverage, and leverage is a powerful thing. Regardless, the downpayment is usually not the biggest barrier.

Credit can be a huge barrier to buying a home, but that's a topic for another day. Instead, let's turn our attention to income. Thanks to the QM standard, DTIs are largely unchanged since 2005 with the exception of the top 10th percentile. I know that you want to point out that the QM standard wasn't around in 2005, and you're absolutely right. My point is that for the bulk of the mortgage market, DTIs have been fairly stable for just shy of 20 years.

So if DTIs are relatively stable since the 2nd Bush administration, and home prices and estimated mortgage payments track strongly together, I would argue that it points to people being payment buyers. Instead of focusing on the top line price of a house when making a purchase decision, it becomes about what payment a borrower can either afford or get approved for. Normally we think of the home value as driving what the payment will be, but instead payments are now driving what the home value is.

This isn't just a housing thing. We no longer buy movies, we pay for streaming services. Car buyers focus on their loan or lease payment, so much so that some auto manufacturers will give you an estimate as to how many dollars extra per month certain options an accessories will cost. The average consumer today looks to see whether they can squeeze an ongoing obligation into their monthly cashflow, and that's how decisions get made.

I'm sure you're wondering about how household income levels play into this. It's a tough question, because we have the combination of the wealth effect - previously a positive in terms of household expenditures, and now likely to become a negative - combined with deferred consumption during the worst of the pandemic. One thing is for certain: the average person who is looking to purchase the average home hasn't seen income increases that keep pace with inflation. Whether their employers targeted the average increase of 4% in compensation that was cited in various articles I read earlier this year, or if they decided to hold the line at a 2% average increase like every other year, wages haven't kept up with this recent bout of inflation. Nor can they. If you believe that inflation has been driven by supply chain disruption and other systemic shocks, increasing wages simply breeds more inflation because higher wages don't instantaneously create an increased supply of goods and services, nor change the individual consumption decisions that gives fuel to inflation.

Ultimately, if you subscribe to my theory that people are payment buyers, home prices will ultimately depend upon people's willingness and ability to curtail other spending to enable them to devote more cash flow towards increasing mortgage payments. I don't have an answer for where the tipping point is on that, but I would look to see what's happening in terms of discretionary spending to help predict how that tradeoff will manifest itself. Regardless, there either has to be pain when it comes to home prices, or discretionary spending, or both. Stay tuned!

In parting, there's one other potential scenario that needs to be considered: the market effectively begins to seize up. Now, I'm not saying that home purchasing would cease to exist, but rather that some people may be effectively "trapped" in their current housing situation. This means that the slack in the system would depend upon involuntary prepayments (foreclosures, pre-foreclosure sale, deed in lieu, etc.) or an increase in the supply of housing stock. It's hard to imagine home starts remaining strong in an environment where builders have increased financing costs, and an uncertain level of demand. In this scenario, volumes would drop, but we wouldn't necessarily see price decreases. What we'd instead see is an elevated level of price volatility, and a decrease in correlation of price movements across the country. If this were to play out, then expect it to have a ripple effect in ways we can't even begin to predict.