Few Move-Up Home Buyers With Higher Mortgage Rates

Home sales are falling, down 20% in the last year. Big declines occurred among people thinking about moving up to a larger, nicer or newer house. The simple arithmetic of home payments drives this decline.

Imagine a family that owned a house an refinanced it in the summer of 2020, taking advantage of low mortgage rates. Let’s say they had put 20% down on the house Mortgage rates averaged 2.94% two years ago, making the monthly home payment about $1,039 for a median priced home of $310,400. (That will seem very low to people in some cities, but it was, in fact, the national median in August 2020.)

Two years have gone by. The house has appreciated by 30%, about the national average. But even though the house is worth more, it’s not larger than it used to be. Let’s say the family would like a larger house, or a newer house, or a house in a better neighborhood. They are thinking of a house worth 25% more than their current house. What will it cost them to upgrade?

The family’s equity has grown thanks to the rising value of their old home. Let’s assume they roll all their equity into a new mortgage. But the new mortgage rate is a huge problem. Leaving their old mortgage behind, they will pay 5.22% if their deal is at the recent average (as of August 2022). Their monthly payments will rise by 85%. If they had started with the median house, their payment would go from $1,039 to $1.922.

Most people will be unwilling to pay 85% more to get 25% more value. Certainly some will hold their nose at the higher cost and move to another city to take a better job. Others really want that third bathroom or the better school district. For most people, though, the value proposition does not work out.

Further aggravating the decline in demand is what economists call “diminishing marginal utility.” The added benefit of going from two bathrooms to three bathrooms is smaller than was the gain of going from one to two bathrooms. The third bath does not add as much value as the second. And the second did not add as much as going to one indoor bathroom compared to an outhouse. The same is true for bedrooms, total square footage, lot size, quality of appliances and so forth.

Income gains can overcome diminishing marginal utility. When people have more inflation-adjusted income, they will spend it on something, and often that’s better housing. But right now incomes are not rising as fast as consumer prices are going up, dampening demand for more expensive homes.

There will be a few people who actually move up, including some who have to move to another city to take a job, and those who have not been spending all their money and now want better digs. In some markets, prices may drop due to weak demand, enabling some folks to move into a bigger home for not such a large increase in cost. Generally, though, the house market will be weak for at least a couple of years.

The only silver lining in this dark cloud is that it will show people—once again—that housing prices do not always rise.