While rising interest rates may lead to more reductions in the housing supply, it may also bring some much-needed balance to the market, according to First American Financial Corp.

First American Financial’s December 2021 First American Real House Price Index (RHPI) found Real House Prices rose 21.7% year over year in December, the highest annual growth rate since 2014. Arizona, Florida, South Carolina, Connecticut and Georgia had the greatest year over year increase. Month over month, real house prices rose 1.9% from November 2021 to December 2021. 

Mark Fleming, First American’s chief economist, said that record increase was driven by rising mortgage rates and rapid home price appreciation. Additionally, the 30-year fixed-rate mortgage increased 0.4 percentage points while the adjusted house price index rose 21.4%, he said. 

“Even though household income increased 5% since December 2020 and boosted consumer house-buying power, it was not enough to offset the impact of higher mortgage rates and rising nominal prices on affordability,” said Fleming in a release. “In the near term, affordability is likely to wane further, as mortgage rates are expected to continue to rise and the pace of house price appreciation exceeds gains in household income. How buyers and sellers react to higher rates may help the housing market regain some balance.”  

Several economic dynamics dominated the market in the second half of 2021 including the pace at which homes are appreciating, rising mortgage rates and the record low supply of homes for sale. And while homeowners have historically high equity in their homes and may feel wealthier, many have also secured historically low fixed-rate mortgages, Fleming said. 

“There is a financial ‘lock-in’ effect that increases as mortgage rates rise and as the size of a mortgage increases,” Fleming said. “Rising mortgage rates increase the monthly cost of borrowing the same amount that a homeowner owes on their existing mortgage. The higher the prevailing market mortgage rate is relative to the homeowner’s existing mortgage rate, the stronger the lock-in effect. Why move out and move down?”

And while unadjusted house prices are 44.5% above the 2006 housing boom peak, the report found “real, house-buying power-adjusted house prices” remain 33.2% below that peak.

What does it all mean? The report found the housing market will adjust as some homebuyers feel “rate locked” in their homes, while first-time homebuyers struggle with limited supply and declining affordability. 

“But what goes up, must eventually moderate,” said Fleming. “Rising rates may be a housing market headwind in 2022, but as some buyers pull back from the market due to affordability and supply constraints and as new construction adds more supply, house prices will moderate, resulting in a more balanced housing market.”