Despite recent drop, mortgage rates may still keep people from moving

New research by Gies Professor Julia Fonseca and her coauthors Lu Liu (Wharton) and Pierre Mabille (INSEAD) shows that recent mortgage rates have made people less likely to sell their homes or move, creating a bottleneck in the housing market.

From the 1980s through 2021, mortgage interest rates were broadly declining and were at historically low levels when the Federal Reserve then started increasing interest rates in an effort to fight inflation. On top of that, mortgages in the US are fairly unique compared the rest of the world. US mortgage rates can be locked in for up to 30 years. The result is that many mortgage holders have ended up having extremely low interest rates. According to Fonseca, as of March 2024, 60% of borrowers had a mortgage interest rate of 4% or less.

However, homeowners cannot keep their current rate if they purchase a new house. If they choose to purchase a larger, more expensive home or something smaller, homeowners would need to take out a new mortgage at a new rate. This can create a dilemma: is it worth it to purchase a new house if the interest payments are going to be significantly higher?

Fonseca, an assistant professor of finance, says it is helpful to view the housing market as a ladder. Homeowners typically move from renting to a starter home, later to a larger home, and perhaps one or two beyond that. As they age, many homeowners downsize when they no longer need a larger home. But with the interest rates where they are, they find that moving to a smaller home would not be beneficial since they would have a higher interest rate on their mortgage.

“Because of lock in, they're stuck,” Fonseca explained. “They're not climbing down, and that is going to make it harder for other people to climb up.  In our model, because these people are staying put, they're not, let's say, transitioning to renting, the demand for these homes increases, and so as the demand increases, prices have to increase. And so, lock-in is going to lead to higher house prices in our model.”

People are simply not moving to the same extent that they had been in the past.

“They're staying put,” she said. “That means that these homes are not being put up for sale. And most home sales in the US are existing home sales. And so, inventory can be going down. There's less liquidity, and it's making it harder for first-time homebuyers to come into the market.”

Lock-in leads to more people aging in place. People who would otherwise downsize to a smaller house feel that the mortgage rates make it more appealing to stay where they are. So, homes that would be a step or two above starter homes are not available for people in the starter homes to purchase, which causes starter homes to be less available. And if more people are staying in rental properties because they cannot move to a home, then the supply of rental property decreases, which in turn increases rents. So, the higher housing costs are trickling down to the rental market.

Fonseca and her coauthors also examined the potential impact of the Mortgage Relief Credit (MRC) that was announced in March 2024 by the White House. This policy would give a $10,000 tax credit to sellers of starter homes, defined as homes that are below the median house price in the county. The intent is to free up more starter homes to help people get started on moving up the mortgage ladder.

“We found that this policy would only very modestly increase first-time homebuying,” Fonseca said. Their analysis showed that the policy only modestly helped promote first-time home buying while have a couple of side effects: house price inflation in high-price areas, regressive effects across the housing ladder, and mobility away from high-opportunity areas. “It does somewhat unlock the owners of starter homes. They do upgrade to larger homes, but it really doesn't help first time homebuyers as much, and so they are not able to kind of take over that space in the housing ladder.”

Now that the Federal Reserve has announced on September 18 that it will reduce interest rates, what will the impact be? Fonseca explained: “As rates climb down, people are going to become less and less locked in and more willing to move. So, in the context of the Fed, that is what I would expect. As rates dip down, we should see people becoming more willing to move. At the same time, there's a lot of pent-up demand as well. There's a lot of first-time home buyers who are looking to get into the market. So, it's tricky to predict what's going to happen in terms of prices.”

Fonseca spoke about this research on the impact of reductions in interest rates on the housing market in a recent episode of Planet Money.