Interest rates on 30-year fixed rate mortgages have increased about one-half percentage point since the presidential election. The Federal Reserve Board has been quite clear in its intentions to raise short-term rates over the coming months and quarters. This has caused much hand-wringing over how the housing market will respond to this challenge. The housing recovery — particularly on the single-family side — has been painfully weak to date, so new hurdles have been met with growing concern.
It’s difficult to put a positive spin on the likely impact of rising interest rates on single-family construction activity. Success for this sector largely will be determined by the ability to get younger households into homeownership. Rising house prices and higher down payment requirements have already created obstacles to this goal. Rising interest rates will create additional affordability challenges.
However, the effect of rising interest rates on home improvement spending is more complicated. First, most owners rely principally on savings to pay for home improvement projects, so rising interest rates matter less. Still, one key source of home improvement funds may be drying up with rising mortgage rates, which is the proceeds from cash-out mortgage refinancing. As owners have been refinancing their mortgages in recent years to take advantage of falling rates, they often find that growth in the value of their home allows them to increase the amount of their loan, and are able to take out some of this built-up equity as cash when they refinance.
Over the past few years, cash taken out at the time of refinancing has averaged about $40 billion a year nationally. Studies have shown that a high share of the money from cash-out refinancing has been reinvested back in their home as home improvements. So, as long-term rates begin to trend back up, we can expect to see much less refinancing activity, which will inevitably reduce funds available for home improvement spending.
However, even as higher interest rates discourage some owners from cashing out home equity to undertake home improvement projects, they may actually promote remodeling spending by others. Rising mortgage rates may lock a lot of owners into their current home. Interest rates for 30-year fixed rate mortgages have been below 5 percent since early 2011, so virtually everyone who has purchased a home or refinanced their fixed-rate mortgage over the last six years has locked into a historically low mortgage rate. As rates trend up, the prospect of trading up to a more desirable home also involves losing their lowest-in-a-lifetime mortgage rate. Many owners may decide that they want to hold onto their mortgage, and instead of trading up to a nicer home, they will improve their current home to get the features that they we hoping to get from trading up.
Those owners who want to tap into their growing levels of home equity to finance their home improvement projects are likely to rely on home equity lines of credit rather than cash-out refinancing. These equity lines are generally structured as revolving loans that adjust with short-term interest rates. The concern is that short-term rates are typically much more volatile than long-term rates. So, the likely reversal of the long-term decline in interest rates is expected to slow down the recovery in the single-family construction market, and reduce the pace of sales of existing homes. Whether this slowdown in household mobility on net will help or hurt home improvement activity is unclear.
However, owners who decide to finance their home improvement projects will no doubt face more risk from rising interest rates as they will increasingly look to more volatile home equity loans to finance these projects.
Kermit Baker is the senior research fellow for the Joint Center of Housing Studies at Harvard University. He may be reached via e-mail at kermit_baker@harvard.edu.