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What Happens to Home Prices When Interest Rates Go Up?

Interest rates are shooting skyward in 2022 as the Federal Reserve tries to tame inflation. Naturally, the question on both homeowners’ and homebuyers’ minds is: “Will higher interest rates also cool the white-hot housing market?”

The conventional wisdom suggests this is often the case. But the data isn’t as clear as most pundits postulate. 

Read on to learn why higher interest rates sometimes reduce home prices — and learn how to navigate the real estate market when interest rates are high. 

What Happens to Home Prices When Interest Rates Go Up?

When the Fed raises interest rates, it raises the interest rate banks charge other banks to borrow money. Banks then pass these higher rates to mortgage borrowers. 

These rate increases have profound effects on real estate markets nationwide. Here’s what tends to happen when prevailing interest rates rise.

1. Mortgage Rates Increase

Mortgage interest rates don’t move in lockstep with the Fed funds rate, but the two are highly correlated. In June 2022, for example, 30-year fixed mortgage interest rates reached 6.28%, more than doubling from a low of 2.78% the previous year. During the same time frame, the Federal Reserve raised the funds rate from near 0% to 1.5% — meaning mortgage rates rose much faster than the underlying benchmark.

Most homebuyers take out a mortgage to cover the cost of buying a house. So we talk about affordability, we measure it in terms of monthly mortgage payments compared to monthly incomes. Mortgage lenders cap borrowers based on debt-to-income ratios.  

Rising rates mean that the same home price comes with dramatically higher monthly payments, dropping home affordability. For example, when the mortgage rate is 3%, a $400,000 mortgage loan costs $1,686 per month in principal and interest. At a 6% interest rate, the same loan costs $2,398 per month in principal and interest. 

In other words, homebuyers just can’t afford to bid as much when making offers. 

2. Homebuyer Demand Decreases

These higher mortgage rates — and higher monthly payments — price some buyers out of the market. They shelve their buying plans and continue renting while saving up more money for a down payment

That reduces demand for home sales, so listings start sitting on the market longer before selling. 

3. The Housing Market Has More Inventory

As demand lags, listings sit longer on the market and housing inventory starts to build. That increases the supply of homes available in the average market, skewing the landscape in favor of buyers.

Sellers Lower Home Prices

This in turn can cause sellers to lower their asking prices, or at least accept lower offers. Homeowners who need to sell urgently are more likely to lower their prices to stand out from the competition. 

At least that’s the conventional wisdom. The data proves murkier however — check out this comparison of interest rates and home sale prices since the early 1970s:

Recessions show a clearer correlation with home price drops than rising interest rates do. If you squint hard enough, you can see…something. But the effect of rising interest rates on home prices doesn’t exactly jump off the page. 

Bidding Wars Don’t Get as Intense

Because lenders calculate loan limits based on the borrower’s income versus the monthly payment, higher interest rates mean borrowers have lower caps on their maximum loan amount. 

They simply can’t keep bidding up prices into the stratosphere. And in markets with more inventory, you see fewer bidding wars in general because supply can more easily meet demand. 

4. Cash Buyers Gain the Advantage

Buyers who can afford to pay in cash aren’t beholden to interest rates or monthly payments. Rising interest rates don’t affect them. If anything, they help by reducing the purchasing power of the average buyer and quelling demand.

If cash is king in real estate during normal times, it’s emperor when interest rates spike. So if you’re in the market for a new house or looking to build a real estate investment portfolio and can afford to make lowball cash offers on properties that interest you, do so. As long as you can keep your patience and make many offers, sooner or later you’ll find a seller who will take you up on your cash offer. 

Should You Buy a House When Interest Rates Are Rising?

If you can afford to buy in cash, then rising interest rates offer an opportunity to buy with less competition from other buyers. 

But if you need a mortgage to cover your home purchase, the math gets murkier. On a monthly basis, you’ll pay more — maybe much more — than when interest rates were lower.

Price Out Adjustable-Rate Mortgages vs. Fixed-Rate Mortgages

You do have a few options available to you. 

First, price out adjustable-rate mortgages (ARMs) in addition to fixed-rate mortgages. Lenders prefer ARMs because they incentivize borrowers to refinance — generating additional fees and interest for lenders. 

To nudge borrowers into ARMs, they offer low introductory rates for the first three to 10 years. That might be enough time for interest rates to drop again, allowing you to refinance at a low interest rate in a few years before your rate starts adjusting upward.

Increase Your Down Payment

You can also reduce your monthly payment by putting down at least 20%. That lets you avoid private mortgage insurance (PMI) and reduces the overall loan amount that you’re paying high interest on. When interest rates are high, it pays to stretch to make a bigger down payment

Consider the Cost of Buying vs. Renting

Finally, first-time homebuyers getting priced out of the market means they continue renting longer than they would otherwise. People always need housing, so lower demand for buying homes means higher demand for renting them. That can lead to rents rising faster than usual. 

In fact, the Fed raises interest rates specifically to combat inflation and an overheating economy — precisely the ingredients that cause rents to jump in the first place. As you decide whether to buy or rent while interest rates rise, remember that renting might not offer much reprieve. 

Final Word

Higher interest rates might put downward pressure on home prices, but that doesn’t make them more affordable. It just means the same monthly payment covers a lower loan amount. 

And the historical data isn’t exactly crystal clear on whether higher interest rates even cause housing prices to fall. Common sense suggests it, but housing markets are complex and driven by many factors, not all of them obvious. 

The post-pandemic housing market of the early 2020s did see significant price reductions in many formerly hot markets. By June 2022, Redfin found that over 40% of sellers in pandemic hot spot markets have lowered their asking prices.

As you explore your options, consider house hacking to reduce or even eliminate your home loan payment. Get creative to use your home as a source of revenue. 

If you can buy in cash, lowball cash offers can find more traction when interest rates are high. Your competition is at a disadvantage, putting you in the perfect position to ferret out urgent sellers with low cash offers. 

G. Brian Davis is a real estate investor, personal finance writer, and travel addict mildly obsessed with FIRE. He spends nine months of the year in Abu Dhabi, and splits the rest of the year between his hometown of Baltimore and traveling the world.