Mortgage rate trap is making the housing market worse

One big factor that helped numerous homeowners save money is ultimately hurting homebuyers. Call it the interest rate trap.

Years of historically low rates, especially in the last two years, have helped millions of homeowners refinance into mortgages with rates between 2% and 4%, lowering their monthly payment by hundreds of dollars.

Now as mortgage rates near 5%, these same homeowners are thinking twice when it comes to trading up, adding to the inventory shortage that is creating an affordability crisis for buyers.

“Existing homeowners have a disincentive to sell because every dollar borrowed costs more,” Mark Fleming, chief economist at First American Financial Corporation, told Yahoo Money. “The financially rational decision is not to sell.”

This week, the mortgage rate on the 30-year fixed mortgage hit 4.72%, the highest level since December 2018, according to Freddie Mac.

A year ago, that rate was at 3.13%. It reached an all-time low of 2.65% in January of last year. During that time, millions of homeowners jumped on the chance to snag a historically low rate.

Now, only 14% of homeowners with a mortgage have a rate of 4.75% or higher — where Freddie’s Mac measure is roughly now. They are also the only pool of homeowners who could sell their house now and buy another at a rate that is similar to what they have — if all the transactions fall in place before rates rise again, an iffy feat given that rates have moved up at the three-month fastest clip since May 1994, per Freddie Mac.

Otherwise, the remaining 86% of homeowners are sitting tight with a mortgage rate of 4.625% or lower.

“There is greater disincentive to move and replace their current mortgagee that likely has a lower fixed rate, lowering housing turnover,” according to a BofA Global Research note.

How big is the disincentive?

Take a homeowner with a $100,000 mortgage at 3%. That homeowner pays $3,000 a year in interest payments on a 30-year fixed rate mortgage, Fleming said. If that same homeowner sells their existing home and purchases another home for $100,000 at 4.5%, the homeowner would pay $4,500 a year — that’s $1,500 more, or $125 more per month.

"So why bring my home to market to sell and become a buyer right away when it will cost more per month?" Fleming said.

And that’s what happening — would-be sellers aren’t selling.

At the end of February, the housing inventory for existing homes totaled 870,000 units, down 15.5% from a year ago when there were 1.03 million units, according to the National Association of Realtors (NAR). Existing homes make up 90% of total home sales.

The result?

"I think there is no question that the low inventory of homes for sale is pushing prices up – probably the primary reason,” David Berson, chief economist and senior vice president at Nationwide Mutual, told Yahoo Money.

The S&P CoreLogic Case-Shiller national home price index posted a 19.2% annual gain in January, up from 18.9% in December.

"While the re-acceleration of home price gains may be concerning, and likely discouraging for first-time and younger buyers, it is nevertheless unsurprising considering the dire inventory of for-sale homes, which continues to decline and continually record new lows," Selma Hepp, deputy chief economist at CoreLogic, said in a statement.

While a seller would get a good price for their home, buying another means facing rising mortgage rates, higher prices on the trade-up home, and an ultra competitive market due to low inventory — a vicious cycle that continues to dissuade homeowners from selling.

“It will slow both demand and supply," Berson said.

There’s another factor at play, too: Inflation, especially as housing costs — both rent and for-sale prices — skyrocket.

Housing — mortgage or rent — makes up a third of most household budgets. Even with maintenance costs and homeowners insurance premium increases, homeownership is still cheaper — because they make up just a quarter of housing-related expenses, according to Fleming. The rest is a fixed mortgage payment.

“Rent is going up faster than inflation in certain areas,” Fleming said. “The best hedge against inflation is homeownership because your housing cost stays the same.”

Editor's note: An earlier version of this story had the incorrect rate calculating how much interest a homeowner would pay. The correct rate is 4.5%.

Ronda is a personal finance senior reporter for Yahoo Money and attorney with experience in law, insurance, education, and government. Follow her on Twitter @writesronda

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