The US housing ‘lock-in effect’ –quantified

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One of the seemingly-odd things about the US economy has been housing’s resilience to a massive upswing in interest rates. In reality, higher rates have helped property prices, because of the unique characteristics of the American mortgage market.

Because of the prevalence of 30-year fixed rate mortgages in the US, most Americans locked in cheap monthly payments in the low-rate era. But if they moved now, they’d have to get a new mortgage at a higher rate. This discourages people from moving, in effect reduces housing supply, and helps support prices.

This is by now a well-known issue, but Federal Housing Finance Agency had a stab at quantifying this “lock-in effect” in a March paper, which FTAV only spotted now thanks to Apollo’s Torsten Sløk.

Here’s the abstract, with Alphaville’s emphasis:

People can be “locked-in” or constrained in their ability to make appropriate financial changes, such as being unable to move homes, change jobs, sell stocks, rebalance portfolios, shift financial accounts, adjust insurance policies, transfer investment profits, or inherit wealth. These frictions — whether institutional, legislative, personal, or market-driven — are often overlooked.

Residential real estate exemplifies this challenge with its physical immobility, high transaction costs, and concentrated wealth. In the United States, nearly all 50 million active mortgages have fixed rates, and most have interest rates far below prevailing market rates, creating a disincentive to sell.

This paper finds that for every percentage point that market mortgage rates exceed the origination interest rate, the probability of sale is decreased by 18.1%. This mortgage rate lock-in led to a 57% reduction in home sales with fixed-rate mortgages in 2023Q4 and prevented 1.33 million sales between 2022Q2 and 2023Q4.

The supply reduction increased home prices by 5.7%, outweighing the direct impact of elevated rates, which decreased prices by 3.3%. These findings underscore how mortgage rate lock-in restricts mobility, results in people not living in homes they would prefer, inflates prices, and worsens affordability. Certain borrower groups with lower wealth accumulation are less able to strategically time their sales, worsening inequality.

We didn’t bold the final sentence above, but it’s an interesting side-argument from the paper’s authors, Ross Batzer, Jonah Coste, William Doerner and Michael Seiler.

Basically, they suggest that affluent Americans can time their sales more strategically, thereby widening wealth inequality over time. And “even with moderate decreases in interest rates, these effects are likely to remain present for years to come”.

Perhaps less importantly, but more geekily, the paper explores the idea of making US mortgages portable or assumable by the new buyer, and what impact that might have. FT Alphaville’s emphasis below:

Mitigating market features that exist internationally or have been used in the past in the United States include (1) portability, where a homeowner could retain financing terms when moving to another home, or (2) assumability, where a seller could transfer mortgage terms to the buyer.

Both possibilities may be worth policy consideration. Portability would presumably be more attractive to both the servicer and owner of the note because only the asset, not the borrower, would change. If so, this might result in a higher “take-up” because the original borrower passes on the full portability benefit to himself instead of splitting the benefit (of having a below-market interest rate) with another party.

Extant studies using FHA and VA loans show that only 1/3 of the benefits from assuming a loan are capitalized into the home’s sale price (Sirmans, Smith, and Sirmans, 1983). Assumability has not faced a receptive interest rate environment to justify its usage, given that mortgage rates have been declining since the early 1980s. A portable mortgage with a greater take-up rate (than an assumable loan) would increase the mortgage’s duration, making the bond more interest rate sensitive.

Furthermore, the increase in duration would be concentrated in loans with low interest rates and below-par market values. Currently, home sales trigger these loans to be repaid at par value. Removing lock-in with portable (or assumable) mortgages would instead force lenders and investors to continue collecting below-market interest on these loans. A higher interest rate would need to be charged at origination for the investors to take on this increased risk. While we identify potential benefits of removing lock-in, the effects on equilibrium interest rates and mortgage pricing could be topics for future research.

As the paper notes, both portability and assumability are possible in Canada, for example. In Denmark, borrowers can even buy back their mortgage at market value.

However, mortgage rates elsewhere tend to be higher, last for shorter durations, and more often are variable rates. The US 30-year mortgage really is a unique beast.

And it’s also worth remembering that the entire US mortgage market is predicated upon non-portability. The scale of repricing such a change could trigger would be immense. Ending the lock-in issue — while probably a good thing — could cause ructions.