Interest rates are intangible but house prices are not. The way most people think about rising interest rates is through their effect on house prices and mortgage payments.
Very quickly: after drifting down for 40 years, interest rates turned back up last year. They started rising at the end of the pandemic and kept rising after Ukraine.
High rates aren’t necessarily bad — the US has had 5 per cent mortgage interest rates for years, and they do okay. The problem isn’t high interest rates so much as rising rates. Rising rates knock the system out of balance. Household budgets get stress-tested. House prices fall along with people’s reduced ability to borrow.
Now rates are rising. What can homeowners, and prospective homeowners, expect next?
First up — how much will rates rise? The OECD is forecasting eurozone long-term interest rates, ie the interest on 10-year government debt, will rise from their current level of 1.7 per cent to 2.1 per cent by the end of 2024. The OECD’s forecast for the eurozone as a whole is almost identical to that of Ireland.
A rise of 0.4 per cent isn’t big. But then, rates have already moved a lot — they were 0.17 per cent at the end of 2021. Those moves are still working their way through the system. Mortgage interest rates do not yet reflect them.
These are interest rates on government debt. How do they translate to mortgage interest rates? Historically in Ireland, the spread between the two numbers has been about two per cent. The last time government debt yielded 1.7 per cent was 2014, when mortgage rates were at 4.0 per cent. The following chart shows average mortgage interest rates in Ireland since 1975.
Let's say mortgage rates went to an average of 4.0 per cent. What then?
30 per cent of Bank of Ireland's mortgages are trackers. A further 11 per cent are variable. If Bank of Ireland is representative, around two in five Irish mortgage holders are sensitive to rising rates in the short term. And everybody else will have to pay more when their fix runs out.
How much would mortgage payments go up? The following admittedly difficult chart shows the relationship between mortgage payments and outstanding borrowing for interest rates of 2, 3 and 4 per cent over 20 years. So for €300,000 of outstanding mortgage debt, at 2 per cent the monthly payment is €1,365; at 4 per cent it's €1,636. For a €700,000 mortgage, you'd be looking at a €630 monthly increase.
That's the story for existing homeowners. What about buyers?
For those struggling to afford a home, higher rates aren't necessarily good. They do lower house prices. But they do so by making buyers poorer. So when it comes to affordability, it's a wash. Cash buyers are in an improved position — but they're not the same people who have been struggling to afford a place.
How much might prices fall? A 2014 study by the New York Federal Reserve found changes in interest rates have less of an impact on house prices than the relaxation of rules around down payments, or an increase in wealth. They found a 2 per cent increase in mortgage rates — which is roughly what we'd be looking at in Ireland — reduces people's willingness to pay by five per cent. The average house in Ireland cost €311,000 in the second quarter of 2022 — a five per cent drop would be in the region of €15,000.
But then, not all housing markets are equally exposed to rising rates. A two per cent rise in mortgage rates would have tanked the 2007 Irish market, which was much more credit-fuelled. Were banks permitted to lend now as much as they were then, house prices would be much higher, and much more vulnerable to changing interest rates.
What might be the signs of a fragile, credit-fuelled housing market that's vulnerable to rising rates? One thing would simply be prices rising faster than other places. In Ireland, house prices have gone up at about the same rate as in other European countries. So if there's a bubble, it's not just an Irish one. The following chart is rebased at 2015 and shows Ireland in the middle of the pack. (Though if it had been rebased in 2012, at the bottom of Ireland's exceptionally deep housing crash, Ireland's house price growth would be stronger.)
House prices alone aren't a great measure because Ireland's crash was so severe. They don't say anything about the relationship between house prices and fundamentals.
The OECD compares house prices to rents. It's a useful measure because it tells you how rents get capitalised into house prices. Like an expensive stock, a richly-valued housing market values houses more highly relative to rents. Unlike house price-to-income ratios, it's not distorted by our peculiar national accounts.
The following chart shows the house price-to-rent ratio for Ireland and other high-income European countries. We come out okay — no sign that valuations are stretched.
It wasn't like this in 2006. Back then, the economist Morgan Kelly, warning about an impending property price crash, wrote: "Rents are ridiculously low. For €2,000 a month you can rent a €1 million house in south-east Dublin, close to the Dart line and surrounded by good schools."
Finally, it's worth looking at household balance sheets — how much debt Irish people have relative to their assets. This shows how sensitive the Irish economy might be to rising rates, which would in turn impact the demand for housing (not to mention the likelihood of a financial crisis). Again, Ireland isn't highly levered relative to rich European peers.
The big assumption in all of this is that the OECD forecast holds up, and government 10-year rates rise only 2.0 per cent, and therefore that mortgage rates rise only to 4.0 per cent.
If that's wrong — if inflation refuses to die down, and rates need to rise further — then all bets are off. At 6 or 8 per cent interest rates, house price falls might not be modest.