This is why mortgage rates of 7% are so much worse for buyers now than they were 20 years ago.

Mortgage rates haven’t been this high for more than two decades, but it’s much worse to be a homebuyer now than then.

Buyers are still traumatized by the memory of historically low interest rates, when they could have afforded much more two years ago. Those still looking in the market today are facing severe inventory shortages as many homeowners keep their properties off the market. This has led to house prices rising at a rapid pace.

Add to that high inflation and decades of stagnant wage growth, and buyers now have less purchasing power than they did twenty years ago, which has turned into an affordability crisis entrenched as interest rates rise.

“Over time, that can have a huge impact, as we’ve seen in recent decades,” Andy Walden, vice president of institutional research and strategy at Black Knight, told Yahoo Finance. “The market has become more reliant on a low interest rate environment to support current house price levels than it has historically.”

Signs indicate a home for sale by owner and open house on January 29, 2002, in Des Plaines, Illinois, a suburb northwest of Chicago. (Photo by Tim Boyle/Getty Images)

Mortgage rates: now and then

The average interest rate on a 30-year fixed mortgage was 7.18% last week after rising to 7.24% the previous week, according to Freddie Mac. This was the third week in a row that the rate had exceeded 7%, and the first time it had happened since April 2002.

“At the time, although mortgage rates were above 7%, they had been around 7% for most of the previous decade,” Lynn Kiefer, deputy chief economist at Freddie Mac, told Yahoo Finance. “The market was completely different.”

In fact, rates averaged 7.66% from 1992 to April 2002, according to data from Freddie Mac. It then began to decline, averaging 6.03% until mid-2006, when the housing bubble peaked.

“The Fed was concerned about the possibility of deflation,” Kiefer said of the early 2000s. “The core PCE price index rose only 1.4% from March 2001 to March 2002. In today’s economy, the Fed is concerned about inflation, with the core PCE price index rising 4.1% year-on-year.”

Today’s homebuyers couldn’t have had a more different experience, with the Fed rapidly raising its benchmark interest rate over the past 18 months. Mortgage rates followed, but only after buyers saw them fall below 3% for more than a year during the pandemic, sparking a frenzy among buyers and a refinancing boom among homeowners.

Read more: What the latest Fed rate hike plan means for mortgage rates and loans

By the end of that record low period, almost no one had a mortgage interest rate higher than 6%. In fact, 91.8% of US homeowners had a mortgage with an interest rate of less than 6% in June, Redfin found. Moreover, 82.4% of homeowners have a mortgage rate of less than 5% and 62% have an interest rate of less than 4%.

“It all comes from how home buyers – and therefore home prices – behave in a low interest rate environment like the one we’ve been experiencing on a large scale for the past 40 years,” Walden said.

Supply and demand: now and then

A construction worker installs windows at a new home in Sun City Mesquite, an active adult community, on April 13, 2023 in Mesquite, Nevada.  (Photo: RJ Sangosti, Media News Group, The Denver Post via Getty Images)

A construction worker installs windows at a new home in Sun City Mesquite, an active adult community, on April 13 in Mesquite, Nevada.

Now, all homeowners with a low mortgage rate don’t want to sell and give away, creating the so-called lock-in effect.

This has resulted in historically low inventory on the resale side and lower sales. What remains in the market is “old and tired stock,” Douglas Yearley, chief executive of Toll Brothers, said on the company’s earnings call last month.

Instead, buyers still on the hunt are heading into the new home market, boosting sales there. Builders have responded by ramping up construction, but not enough to make up for the shortage of homes.

Demand remains strong, but volatile.

Millennials – now the largest generation – have entered their prime family and home-buying years, but small increases in mortgage rates have priced in many of them. The number of home orders dropped as rates exceeded 7%.

“It’s a very interesting picture right now,” Jessica Lautz, deputy chief economist at the National Association of Realtors, recently told Yahoo Finance Live (video above). “We have a lot of strong demand for housing. There are a lot of consumers sitting on the sidelines. However, interest rates continue to rise.”

Two decades ago, the picture was different.

And while the economy entered a recession for eight months beginning in March 2001, the effects were unaffected by retail sales and housing for most of that year, according to a Bureau of Economic Analysis report from 2002 that chronicles the labor market in 2001. It was only until consumer confidence began to wane. In the second half, after the terrorist attacks of September 11, 2001, and high unemployment rates.

The report found that “lower mortgage rates and steady consumer confidence supported housing construction, at least through the middle of the year.” “Existing home sales, like those of new homes, were near two-year levels through most of 2001, and real estate employment was consistent with this steady trend.”

In fact, the level of single-family starts, new home sales, and existing home sales was higher than it is now.

The volume of mortgage applications for purchases also continued to rise in the early 2000s, which is an indication of steady demand and the opposite of what is happening today.

“Rising home values ​​have boosted the investment side of home buying, in sharp contrast to lower stock prices,” the BLS report said.

Home prices: now and then

Both eras saw large increases in home prices. But the latest rally has surpassed that of two decades ago.

When mortgage rates hit historic lows during the pandemic, buyers armed with cheap financing drove up rates. From January 2020 to the June 2022 peak, prices jumped 45.15%, according to the S&P Case-Shiller National Home Price Index.

Buyers “raise their budgets and increase competition in the market, which causes house prices to rise much more than income as buyers are able to leverage the same income to purchase a more expensive home,” Walden said.

Although prices have slumped for seven months from last year as buyers balk at higher mortgage rates, they have started to recover this year and are still 45.12% higher than they were in January 2020 – far from their all-time highs.

Home prices were also rising twenty years ago, but not quite at the same pace.

The change in home values ​​between January 2000 and June 2002 was 22.3%, or about half the growth rate experienced by buyers in a similar 18-month period between before the pandemic and the peak of 2022. From January 2000 to June 2003, prices increased by 33.23%, which is lower than the comparable period in the 2020s.

“Although the median price of existing single-family homes continued to grow, affordability also rose, thanks to moderate mortgage rates,” the BLS report said.

Affordability: Every now and then

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A “For Sale” sign is displayed in front of a home in Arlington, Virginia, on August 22. (Photo by Andrew Caballero-Reynolds/AFP via Getty Images)

The biggest difference between now and then may be affordability.

In April 2002, it took 27% of the average household’s income to afford the mortgage payments to buy an average home. That’s just below the average of 27.76% dating back to 1975, according to figures provided by mortgage technology and data provider Black Knight.

In comparison, today’s buyers spend 38.30% of the average household’s income to buy a median-priced home.

Another way to look at it is to measure the median home price to median income ratio.

From 1975 to 2000, the median home price was, on average, 3.6 times the income of the average household. Today, that number has jumped to 5.9 times median earnings — just under the six times that reached last summer before prices began to correct, Walden said.

“The last time interest rates were at that level, house prices, which rose 160% over that period, rose at twice the rate of income, which rose only 80% over that period,” Walden said.

“All of this works well until interest rates rise sharply, which means that you are no longer able to benefit from the same dollar income to the degree that you have in recent years, which puts a huge pressure on affordability,” he said.

Gabriella He is the personal finance and housing correspondent for Yahoo Finance. Follow her on Twitter @__gabrielacruz.

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