Inflation is not rising at the rate it was earlier this year, but prices are still going up, and the Federal Reserve is expected to continue to increase rates.

Though lower than some increases during 2022, the jump in the CPI shows that inflation shows no signs of abating anytime soon. Inflation leads to higher interest rates because it devalues the U.S. dollar, reducing investor demand for mortgage-backed bonds. As demand drops, the prices for mortgage-backed securities fall, leading to higher interest rates for all mortgage types.

Mortgage interest rates, which peaked at just over 7% in the fourth quarter of 2022, and parts of 2023, had been expected by many economists and others in the mortgage industry to stay above 6% for at least the next several months. That was before the recent failures of Silicone Valley Bank and Signature Bank, leading to concerns about the banking industry as a whole.  Rates dropped slightly more than 25 basis points shortly after the failures were announced, but were still at 6.75%

Moody’s Analytics expects housing to weaken through 2025. Declining prices and slowing sales will weigh on future originations; however, they will also affect the performance of mortgages already on the books.

With that in mind, lenders and MSR owners should consider the following impacts of inflation:

• With mortgage rates about double what they were a year ago, very few mortgages will be paid off early. Even homeowners who need to move due to a job change or a change in life situation (retirement, marriage, divorce, etc.) are better served by renting out their current home and buying a new one, using the rent payment to pay off the old mortgage. A Moody’s Analytics study comparing 2018 and 2022 mortgages found that the younger ones tend to have lower prepayment rates. The rising rate environment will further incentivize borrowers to avoid prepayments.
• The higher rates will also push some borrowers to opt for longer-amortizing, 30-year, fixed-rate mortgages even though they can get a lower interest rate — but higher monthly payment — with a 15-year mortgage.
• With fixed-rate mortgages staying near the highest levels in more than a decade, there could be an increase in the demand for adjustable-rate mortgages and their lower teaser rates. This would enable the borrower to take on a larger mortgage in anticipation of refinancing when rates come back down. However, for this to work, rates would have to drop before the adjustable-rate mortgage moves above its initial rate.
• The high interest rates could also keep the percentage of all-cash buyers at elevated levels. According to a Washington Post article, nearly 30% of buyers paid cash in 2022. Sellers prefer an all-cash offer and often will accept a lower price to get their money immediately.
• The higher interest rates also negatively impact the builder’s market. Lumber prices have fallen significantly from a year ago. In March 2022, the price of lumber was around $1,460 for 1,000 board feet, according to ABC News. By January 6, 2023, those prices had fallen by nearly two-thirds to $354. However, the price of other building materials and labor have risen, so builders are not developing “starter” homes — there is no profit in it.

For builders with unsold inventory, the carrying cost of these properties is much higher. As a result, some home builders are seeing losses. Those losses, combined with reduced sales, mean that financially strapped builders abandon some projects while also selling off inventory to investment groups rather than buyers to remove inventory from the books and cover their expenses, a Forbes article points out.

Final Thoughts

The low to nearly nonexistent inflation of a few years ago is gone for the foreseeable future and, along with it, the historically low rates of mortgages that are in many investors’ portfolios. The Mortgage Bankers Association (MBA) expects mortgage origination volume to drop about 15% in 2023 compared to 2022 to about $1.9 trillion — $1.45 trillion in purchase originations and $449 billion in refinances. Mortgage investors will want to take those expectations and the factors outlined earlier into account as they manage their portfolios in 2023.