I wish I knew how interest rates affect houses, but I’m too embarrassed to ask

High house prices are often blamed on a shortfall of supply. That is, prices are high because we aren’t building enough houses. However, a far more important driver of high prices is interest-rate policy.

“UK house prices and three decades of decline in the riskfree real interest rate” is a working paper from the Bank of England written by David Miles and Victoria Monro and published in 2019. The authors conclude that the sharp rise in house prices relative to incomes between 1985 and 2018 “can be more than accounted for by the substantial decline in the real risk-free interest rate” (the yield on medium-term UK government debt, adjusted for inflation) during this time.

What does that mean? The easiest way to think about it is to consider the impact of falling interest rates on borrowing costs. Most of us purchase a home using a mortgage. When deciding how much we can afford, the important variable is not the overall loan – it’s the monthly payment.

Let’s assume you want to take out a 25-year repayment mortgage (so you own the house at the end of the term, rather than an interest-only loan) and you can pay £750 a month. At an interest rate of 7.6%, you can borrow £100,000. At a rate of 3.5%, you’ll be able to borrow £150,000. So lower interest rates turn into higher nominal house prices, because buyers can afford to borrow more to spend.

Miles and Monro conclude “that a 1% sustained increase in index-linked gilt yields” could, in the long run, result in real house prices falling by around 20%. This implies that rising rates represent a headwind (at least) for prices.

None of this is to say that the number of houses built, planning laws, tax policy, immigration, and many other factors have no effect on the housing market. But it is hard to argue that any of these are more important than interest rates, particularly given that this is a phenomenon seen around the globe.