How Debt Affects the Relationship Between House Prices and Mortgage Rates

Views and opinions expressed are those of the authors and do not necessarily represent official positions or policy of the Office of Financial Research (OFR) or U.S. Department of the Treasury.

Residential real estate is an important asset class to consider when assessing the stability of the financial system due to its size and interconnectedness across households, banks, and nonbank financial institutions. Mortgage rates often change in lockstep with policy news and market events, and as these rates fluctuate, so do house prices. For example, when mortgage rates increase, house prices decline. But different parts of the country seem to respond differently—in some parts, prices might respond quickly and decisively while, in others, they might barely move at all. In the OFR working paper, House Prices, Debt Burdens, and the Heterogeneous Effects of Mortgage Rate Shocks, William D. Larson, OFR Supervisory Researcher, and Andrew B. Martinez, Senior Economist at the Department of the Treasury, estimate what causes house prices to move with mortgage rates across cities in the United States. They uncover three main factors that predict a city’s responsiveness: (1) a city’s recent debt service-to-income (DTI) ratio for mortgage borrowers, (2) national mortgage underwriting standards, and (3) the city’s ability to quickly construct new houses in response to changing prices, which is “supply elasticity.”

To arrive at these conclusions, the authors collected house price appreciation data for more than 250 cities over the last 25 years. Then they identified unanticipated mortgage rate changes using professional forecast errors of future mortgage rates and changes in Treasury rates occurring around monetary policy announcements. Estimates across a battery of models suggest that mortgage rate shocks have larger effects on house prices when borrower DTI ratios are extreme, DTI-based underwriting policy is stricter, and the elasticity of housing supply is low. Areas that are more sensitive to mortgage rates tend to include West Coast and Northeast cities. Lower sensitivity areas tend to include cities that are smaller and in the South. Over time, changes in mortgage underwriting and borrowing patterns have made the U.S. more sensitive to mortgage rate changes.

Overall, this research highlights how mortgage rates have different effects on house prices across space and time. Additionally, using the insights from this paper, researchers, policymakers, and market participants will be able to better assess the downstream effects of different types of interest rate shocks on mortgage-backed security prices, the balance sheets of banks and households, and other financial stability-related concerns.