High Mortgage Rates Stir Up Demand for Smaller Homes

This week mortgage rates increased, again surpassing the threshold of 7% for the fixed 30-year term. This week, fixed mortgage interest rates rose across the board while adjustable mortgage rates were down slightly.

As of May 18, here are the current mortgage interest rates without discount points, unless otherwise stated:

Purchase loans with VA: 6.24% plus 0.05 points (up from the 6.22% of a week earlier).

Mortgage rates are likely to remain at this level until the incoming data on the economy makes it clearer where the economy is headed.

In a statement dated May 18, data analyst Hannah Jones of Realtor.com made the following statements:

Since the Federal Reserve began increasing the federal funds rate at the beginning of 2022, mortgage borrowing costs have remained high. Inflation has fallen since then, but it remains above the Fed's 2% target rate. The job market, on the other hand has remained steadfastly strong with an unemployment rate that is still close to historic lows.

Jones states that "Recent data show signs of a stubborn economy, but one that is slowing down, suggesting the Fed's contractionary measures are having the desired effect."

As lenders tighten up their balance sheets, and implement more stringent credit requirements following the turmoil in the banking sector, inflation is expected to continue to fall in the months to come.

The Fed will not cut rates until it sees tangible progress in reducing inflation. This will result in high mortgage rates. All eyes are on the latest economic data, including consumer prices and job market.

Homebuilders are starting to build smaller homes, a return to sanity. But they're also doing it to help combat affordability issues. According to U.S. Census Bureau statistics dating back to 1999, the median square footage of a new house construction that started in the first three months of 2023 is 2,261. This is down from the peak of over 2,500 square foot in 2015.

The trend of downsizing is a result of the fact that more people are buying new homes, while existing homeowners continue to be reluctant to sell because they risk losing their record-low mortgage rates. According to the National Association of Home Builders, in March, 33 percent of homes for sale were brand new homes. This is up from 12.7% on average between 2000 and 2019.

Robert Dietz, Chief Economist at NAHB, told Realtor.com that "when you see an increase of interest rates and a decrease in housing affordability, there is a slight shift in the market towards smaller homes."

Still, the construction of starter homes is far below what's needed to meet demand. Freddie Mac defines a "starter home" as a house that is 1,400 square foot or smaller. According to the Census Bureau, only 3% of all new construction homes sold by 2021 will fall into this category. This is down from 11% back in 2003. A third of the new homes sold in 2021 are between 1,800-2,399 square foot, while a quarter (23%), is 2,400-2,999 square foot.

In 2021, only 24% (or fewer) of all newly built single-family homes will be priced below $300,000. In 2002, 79 % of all new homes were sold at that price.

Over the past few decades, new construction houses have grown in size and cost. The McMansion is a slang term for an unnecessarily big, yet cheaply built house. Merriam-Webster summarizes it well: "a large house, usually built in a suburb or development," especially "one that is regarded as oversized and extravagant."

Homebuilders are now embracing a need for smaller homes. This raises the following question: Does a reduction in the square footage translate into a lower price of a home? Is it a way to save money for the homebuilders while keeping prices high due to consumer demand?