The gap between existing mortgage rates (under 4.25%) and new rates (over 6.25%) is over 200 basis points. This spread, which disincentivizes homeowners from selling, has persisted for three consecutive years. Historically, the gap only exceeded 100 basis points for a total of eight quarters over the past four decades, making the current situation a major anomaly.
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While falling mortgage rates will improve affordability, the "lock-in effect" for existing homeowners with ultra-low rates will persist. This will suppress the typical sales volume rebound, leading to an anemic 3% growth in purchase volumes, a historically tepid response to improved affordability conditions.
Proposals to allow homeowners to take their low-rate mortgages with them (portability) or transfer them to a buyer (assumability) cannot be retroactively applied due to contract law. Creating new mortgages with these features is possible, but the added benefits to the borrower would likely result in a higher, not lower, interest rate.
A sustainable recovery in housing activity requires a roughly 10% improvement in affordability. Morgan Stanley calculates this threshold will be met when mortgage rates fall to approximately 5.5%, a specific target needed to meaningfully "unstick" the market from its current low-activity state.
With high interest rates freezing the existing home market, homebuilders are successfully competing by using their own margins to "buy down" mortgage rates for customers. This strategy allows them to continue selling inventory even when affordability is broadly challenged.
Fed rate cuts primarily lower short-term yields. If long-term yields remain high or rise, this steepens the curve. Because mortgage rates track these longer yields, they can actually increase, creating a headwind for housing affordability despite an easing monetary policy.
A significant housing market recovery requires a substantial and sustained improvement in affordability. Analysts estimate a 100-basis-point drop in mortgage rates (e.g., to 5.5%) is needed to trigger a meaningful pickup in sales. However, this growth is not immediate; sustainable increases in sales volumes typically materialize a full year after the affordability improvement occurs.
A major driver of today's housing scarcity is that homeowners, particularly Boomers, who refinanced into sub-3% mortgages have no financial incentive to ever sell. This seemingly positive economic condition has had the negative side effect of locking vast amounts of housing inventory in place, worsening the supply crisis.
The bond market is a better indicator for mortgage rates than the Fed. The current spread between 5-year and 10-year Treasury notes implies that investors expect the 5-year note's yield to be 100 basis points higher in five years than it is today. Since mortgage rates are closely tied to these yields, this suggests a potential for higher, not lower, mortgage rates in the medium term.
A significant cause of today's housing inventory shortage is that homeowners are locked into low-interest mortgages. "Portable mortgages," which are being actively evaluated by the FHFA, would allow homeowners to transfer their existing mortgage to a new property, removing the financial disincentive to move and potentially unlocking market liquidity.
Morgan Stanley analysts argue that mortgage rates follow the 5- and 10-year Treasury yields, not the Fed Funds rate. As evidence, they note that while the Fed has cut rates by 100 basis points over the past year, the average mortgage rate has actually increased by 25 basis points during the same period.