Mortgage Rates Are Above 7%. Is It Better to Rent or Buy a Home Right Now?

Ivanna Hampton: Welcome to Investing Insights. I’m your host, Ivanna Hampton. High interest rates and expensive home prices are keeping some frustrated buyers on the sidelines. A 30-year fixed-rate mortgage recently crossed the 7% line and remains there, according to the Mortgage Bankers Association. And recently there’s an uptick in some buyers choosing adjustable-rate mortgages that come with a lower loan rate, but higher risk. Meanwhile, macroeconomic conditions are also squeezing homebuilders. So, when could affordability return to the housing market and where can investors find cheap stock opportunities? Suryansh Sharma is the director of equity research for Morningstar and covers the housing industry. Thanks for joining me, Suryansh.

Suryansh Sharma: Thanks for having me here.

Hampton: Let’s start with the current state of the housing market. A number of factors are weighing on it. As an analyst, talk about what’s going on, especially what’s happening in this chart.

Sharma: Right now, the US housing market is under a lot of stress. Mortgage rates are quite high. Housing affordability remains the biggest concern. Housing starts, which denotes that new housing that is getting started, is going down. But if I just look at the pipeline and the amount of inventory that is coming in the market, which is almost a reflection of supply, I think that remains decent. What all of this means is that home prices, in my opinion, will probably remain under some stress for the next two years or so. What we can see in this chart is this, essentially, shows the balance between buyers and sellers. The way I like to think about it is who has more negotiating power. For example, after the pandemic, the number of buyers in the market was materially higher than the number of sellers, which meant that sellers had more negotiating power, resulting in a seller’s market. Right now, the tables have completely turned, and there are many more sellers compared with buyers, which means that we are in the buyer’s market.

Hampton: We’re in a high interest rate environment. The Federal Reserve raised interest rates in September. There are expectations of another rate hike this year. How are higher rates affecting buyers?

Sharma: Higher rates directly affect buyers in the sense that they impact affordability. When houses are less affordable, it directly impacts the health of the US housing market. Just to put my statement in context, from 2020 to right now, the median US existing home price has increased by more than 50%. On top of that, mortgage rates have also risen quite substantially. So, higher home prices plus higher mortgage rates. What it means is that the monthly mortgage payment is now much higher, which means that affordability is under stress.

Hampton: Many homeowners have cheap mortgages on their homes they don’t want to sell. What has your research shown about this barrier? Talk about this chart showing the number of cheap mortgages falling over time.

Sharma: What we can see in this chart is a mix of mortgages over time, and what the different colors show are the mortgages with different effective rates. For example, after 2020, and in 2020 and 2021, cheap mortgages, or mortgages less than 4%, they had risen a lot, but since then we have been seeing a steady decline. The effect that you’re talking about is the lock-in effect. The lock-in effect is basically when the difference between in-affect mortgage rates, the rates that you as a homeowner is paying, versus market mortgage rate, that is when the difference is large, there’s a very strong incentive for you as a homeowner not to move, which is the case right now. What it eventually means for the housing market is that the total number of transactions, especially in the existing home market, will probably remain quite low.

Hampton: Homebuilders typically offer incentives to buyers to close the deal. How are they handling their own financial pressures?

Sharma: For homebuilders, what they are trying to solve is they’re trying to solve for the affordability of the monthly mortgage payment. And what they’re trying to do right now is, because the mortgage rates are very high, the most famous, the most popular incentive among them is the rate buydown. What rate buydowns are, for example, if right now the mortgage rates are 7.5%, they will provide a preferential rate of, let’s say, 5% to you as a homebuyer. But in order to provide that, they would have to pay a big amount upfront. The way I like to think about it is they’re almost trading volume at the expense of margins. They’re getting the volume that they want to run their business, but their profitability is lower as a result of that.

Hampton: What’s your outlook for existing homes versus new homes? What’s the story in this chart?

Sharma: I think there’s been a very interesting dynamic that’s been playing out in the housing market, and we try to show this within this chart. Over the last three years or so, the existing homes have been performing generally much better in terms of how the pricing has evolved compared with new homes. If you look at the very long-term history, new homes generally have been about 20% more expensive compared with existing homes. Right now, that’s not the case. The new home premium has turned into a new home discount right now. New homes are cheaper than existing homes. In our opinion, the reason why this has happened and the divergence of the last three years is partially a reflection of the fact that the amount of existing home inventory was very tight. But I think that is normalizing. We are already seeing that normalize. And as it continues to normalize, I think existing homes will come under more pressure. Existing home prices will come under more pressure.

Hampton: Since it’s less affordable to buy a home, some folks are choosing to rent. Let’s pull up this chart comparing mortgage monthly payments versus rent. Tell us what’s going on and what it means for the future of homeownership.

Sharma: What this chart shows is, if you look at the bars, the bars essentially show a monthly mortgage payment as a percentage of household income. What we can see is, starting in 2022, we can see a big jump, and it’s not come down. Essentially, this chart shows the extent to which affordability is a problem right now. If you look at the line, the line essentially compares the affordability of renting a home versus buying a new home. When the line is above one, it makes much more sense to rent a home versus to buy a new home, which is the case right now. We see that in the markets right now, and what happens with homeownership rates are partially a reflection of this dynamic.

Hampton: What other risk could further weigh down the housing market? Could we even see higher mortgage rates on the horizon?

Sharma: It’s very difficult to see what will happen in the near term. Can the rates be even higher? They definitely can be. And if that happens, that would mean more pressure on the housing market. What I would say is if the rates remain where they are right now, given the supply/demand balance that I’m seeing, given the new inventory that is coming to the market, if that is the scenario, I don’t think we’ve seen the bottom of the housing market in this cycle yet.

Hampton: As a follow-up, which I love to ask, when does Morningstar expect mortgage rates to decline?

Sharma: Our base case scenario is that we expect mortgage rates to go down to about 6% on average by 2028. We expect inflation to soften in the next two years or so, and then we expect the fed-funds rate to start declining in the second half of 2027.

Hampton: Let’s talk about how the housing market’s troubles have created some opportunities in the stock market. Where can investors find undervalued stocks?

Sharma: The softer housing market has definitely impacted the valuation of a lot of housing-related stocks. One of the names that we like is Lennar. Lennar is one of the largest US homebuilders. Lennar stock has been under a lot of pressure, and that’s a reflection of what’s happening in the housing market, but also company-specific issues. Lennar moved from a land-heavy strategy, which is owning land on its balance sheet, to optioning land, which is the land-light strategy. As it was aggressively moving to this new strategy, it made some unfavorable deals, which led to lower margins in its core homebuilding business. What’s implied in the current stock price for Lennar is that their depressed margins will never recover, which we think is just too pessimistic.

Hampton: When you’re talking about margins, you mean what?

Sharma: With margins, I mean profitability. So, the amount of homebuilding profit divided by revenue.

Hampton: Gotcha. What are the key takeaways here as uncertainty ripples through the housing market?

Sharma: For me, the biggest takeaway is, if you think about the near term, there’s a lot of uncertainty; the outlook definitely looks challenging, but from a long-term perspective, we are constructive on the US housing market. If anything, we think that this pullback offers long-term-oriented shareholders to buy some quality names on the cheap.

Hampton: Suryansh, thank you for coming to the table.

Sharma: Thanks for having me.

Hampton: Higher costs and sticker shock have become a part of everyday life, and we’re bringing you a new segment on Investing Insights called Ask the Economist to simplify what’s going on. Morningstar’s senior US economist, Preston Caldwell, tracks the biggest trends, and he’s ready to answer this week’s question. Thanks for being here, Preston.

Preston Caldwell: Thanks for having me, Ivanna.

Hampton: The US midterm elections are coming up, where voters will elect members of the House and certain senators. This comes as food and gas prices are on the minds of many of them. Let’s talk about how the election and economy can intersect.

Caldwell: Yeah. Let’s start with the scenario where the Democrats capture at least the House. Nate Silver is a forecaster that I highly respect, and his model puts a 90% probability on that happening. Obviously, this could be wrong if the polls are wrong, but let’s run with it. What we’ve seen over the last 20 years is that divided control over government, where the president comes from one party and at least one House in Congress is controlled by another party, tends to produce gridlock. That’s not to say that it’s entirely uneventful. We’ve had a number of debt ceiling standoffs, most recently in 2023, which have seemed very worrying at the time, but at the end of the day, each of them was resolved with little sustained damage. What does gridlock mean? It means little, if any, major new legislation, so probably few big policy changes. In that sense, there’s not really a lot to talk about in terms of the election on the overall economy because we’re mainly just talking about business as usual.

Hampton: Now, as a follow-up, how can an election affect people’s personal economy?

Caldwell: Yeah, I mean, so when I say there’s not a lot to talk about in terms of the overall economy, it is true that for particular people, the election could have more impact at an individual level. For people who, let’s say, purchase their health plan on an ACA exchange, then the prospect of higher subsidies for those plans could be very impactful for those people. But just for the overall economy, it’s hard to envision the kind of changes under divided government that could move the needle.

Now, obviously, thinking about policy changes, some resolution of the US-Iran war that fully alleviated the constraints on oil and gas supply coming out of the Gulf, that could be very beneficial in terms of bringing down energy prices, but markets actually have been expecting that to happen, some sort of eventual resolution of the war, actually regardless of which party lands in control of Congress. And I actually do think that makes sense in the long run to me. Just to wrap things up, I would say elections can be important, but I do think that most people overrate the impact of them on the overall economy and financial markets relative to other drivers that emanate from outside of politics, like the rise of AI.

Hampton: Preston, thank you for joining me for Ask the Economist.

Caldwell: Thanks for having me. I enjoyed it.

Hampton: Before we go, here’s what’s ahead on the next episode of The Long View. Co-host Christine Benz and Amy Arnott will chat with historian Joseph Moore about his latest book, How to Get Rich in American History. You don’t want to miss that. Check out the new podcast episode on Tuesday, Oct. 27. I appreciate you for checking out this week’s Investing Insights. Thanks to senior video producer Jake Vankersen and associate multimedia editor Jess Bebel. I’m Ivanna Hampton, editorial multimedia manager at Morningstar. Take care.