The housing market is complex. Prices are driven by a wide variety of factors that are local, regional, national and global. While basic concepts like supply and demand come into play, other things like mortgage rates, inflation and even economic conditions in other countries all influence the housing market. Here, we’ll break down how various factors impact the cost of housing in America.

Inflation and housing

Inflation is the process through which money loses purchasing power. The annual inflation rate as of March 2023 is 5 percent, according to the U.S. Bureau of Labor Statistics’ Consumer Price Index, meaning something that cost $100 12 months ago would cost $105 now.

Inflation impacts the housing market in a few ways. Most importantly, just as it causes the price of consumer goods to increase, it causes the home prices to rise as well.

However, one of the Federal Reserve’s goals is to try to control inflation and keep it at a steady, low rate. As we’ve seen in recent months, if inflation rises significantly, the Fed might increase the federal funds rate to reduce the money supply and reduce the inflation rate. This increase in the federal funds rate can cause mortgage rates to rise — and rising mortgage rates can decrease home buying demand, leading to a fall in home prices.

Federal funds and 10-year bond rates

The federal funds rate is a benchmark interest rate determined by the Fed. This is the interest rate that banks charge when lending each other money overnight. It’s called a benchmark rate because it winds up serving as a benchmark for many other interest rates: Everything from savings accounts to credit cards set interest rates in part based on changes in the federal funds rate.

Bonds, such as the U.S. government 10-year bond, also have interest rates that are influenced by the federal funds rate. Historically, the interest rate on 30-year mortgages have moved in tandem with changes in the 10-year Treasury bond rate. As the 10-year bond rate sees rate increases, mortgage rates rise. The same is true for rate decreases.

Mortgage interest rates

Current mortgage interest rates, which are impacted by the federal funds rate and other market rates, influence the price of housing.

When mortgage rates rise, that leads to an increase in the monthly payments for a loan of the same amount. For example, at a 4 percent interest rate, a $250,000 mortgage would cost $1,194 per month. At 6 percent, the same loan would cost $1,439 per month. The effects are even greater for larger loans.

The housing market saw this in action in 2022, as rates shot up from 3.4 percent in January to 7.12 percent in October. As of March 2023, they currently sit at around 6.6 percent. This phenomenon can make it harder for many people to buy a home — and push some hopeful first-time buyers out of the market entirely.

According to Allyson Waddell, an agent success manager at housing website RealtyHop, recent increases in rates have had a big impact on purchasing power. “With mortgage interest rates around 6 percent, American homebuyers have 24 percent less spending power than they did a year ago.”

Housing inventory and new construction

Supply and demand are two simple factors that influence the price of all goods and services. If more people want a thing, prices tend to rise. But, as more of that thing becomes available, prices fall.

Housing inventory can be impacted by many factors. New construction is a major way to add more supply to the existing housing market. However, new construction can be slowed by rising labor and materials costs. Rising interest rates and falling home prices also slow down construction, which limits supply increases in the housing market. Supply-chain issues, as we saw during the height of the pandemic, can also cause problems.

Currently, the demand for homes far outpaces the supply, resulting in a housing shortage. As of March 2023, the market had about a 2.6-month supply of homes on the market, according to the National Association of Realtors. That’s well below the 5 or 6 months typically needed for a balanced market. “Housing construction is not increasing at the level needed to combat the shortage,” says Waddell.

Politics can also play a role in housing construction, with zoning restricting the construction of things like apartments and condo complexes that could create additional housing supply. In recent years, large investors have bought up properties to turn them into rentals, further constricting the supply of homes available for people to buy.

Local market factors

Local factors impact housing prices in many ways, generally by influencing the demand for homes. For example, if a major employer in the area shuts down and many people lose their jobs, that can reduce demand for housing and cause prices to fall. Other factors, like the quality of the school district, pleasant weather and proximity to major cities or desirable amenities can drive up demand.

In addition to impacting an area’s home prices, the level of supply and demand in a local area also influences whether buyers or sellers have more negotiating power. For example, Seth Bellas, a home loan specialist at Churchill Mortgage, notes that decreased demand from buyers has made sellers more willing to negotiate.

“Higher rates do put a strain on lower-middle class borrowers because of the higher payments,” Bellas says. “But the slowdown has also made it possible, in some cases, for those same buyers to get closing costs covered and get offers accepted with the contingency of selling their current home. We have also seen an uptick in VA and FHA offers being accepted, whereas in the more competitive environment, these offers were often snubbed by sellers.”

Bottom line

Predicting the future of the real estate market is difficult even for the experts. Some believe that stubbornly high rates and an economic slowdown will force home prices to fall. Others insist that inflation and inadequate housing supply will lead to prices holding steady or continuing to rise. And if the nation does fall into a recession, as many fear, the housing market’s struggles may become even more pronounced.

No matter what happens to the real estate market over the rest of the year, if you’re thinking about buying or selling a home, it’s a always good idea to work with a knowledgeable real estate agent. A good agent can give you insight into your local market and determine a fair price for properties in your area.