With interest rates at their highest in decades, recent homebuyers have grown reluctant to move and lose their exceptionally low rates. When mortgage rates rise significantly, this “lock-in effect” can affect the housing inventory of houses for sale, lower relative liquidity in the housing market, and make it more difficult for homebuyers to find a home.
- The lock-in effect happens when homeowners are unwilling to sell their homes because they are unlikely to match their current interest rate should they buy a new home.
- It can be caused by rising interest rates, discouraging homeowners from giving up a low rate.
- The lock-in effect can cause the housing supply to decline and therefore, increase prices.
What Is the Lock-in Effect?
The lock-in effect occurs when homeowners are hesitant to sell their homes. These homeowners are said to be locked into their properties and mortgages, limiting the number of homes available in the housing market.
There are many elements that cause the lock-in effect: interest rate increases, changes in capital gains taxes, shifts in housing prices, economic uncertainty, and higher levels of debt or negative equity. It’s anything that makes homeowners less willing to sell their home if they’d otherwise be interested in doing so.
The Potential Causes of the Lock-in Effect
Here are some of the reasons homeowners might be “locked-in” to their homes:
High Interest Rates
A major contributor to the lock-in effect in the early 2020s post-pandemic period has been the rise in mortgage rates, especially after years of historically low rates.
Suppose a homeowner in 2020 bought a home using a $500,000 mortgage with a 2.5% interest rate. Assuming a 30-year term, they’d pay $1,976 per month, and that loan would cost $711,360.
If this person sold the home and got a new $500,000 mortgage at a rate more common later, such as 7.5%, their monthly payment would rise to $3,496, an increase of $1,520. The total loan cost would increase by over half a million dollars to $1,258,560.
A 2023 survey conducted by Fannie Mae found the top reason that homeowners were likely to stay in a home longer than planned was because of a low mortgage rate. Another 2023 study found that moving rates fell by 9% for every 1% increase in mortgage rates.
The Fannie Mae study, however, showed why and when people choose to move can be complicated. About 29% of mortgage borrowers surveyed by Fannie Mae said they plan to stay in their homes longer than they would have otherwise. About 21% of those (or just 6% of all mortgage borrowers) said this was because they had a low mortgage interest rate, but almost as strong were “I like the home/location” at 19% and 13% each for “my job and family are located here” and “home prices are too high to buy.”
Changes in Laws and Regulations
Some markets may have a lock-in effect because of changes in laws and regulations. For example, California’s Proposition 13, enacted in 1978, has long been thought to lock Californians in their homes. This limited property tax increases for current owners to no more than 2% per year. When a home is sold, taxes are reassessed, so the new owner must pay far more than the previous owner. So, if you live in California, you’d risk much higher yearly property taxes if you moved.
This also provides some greater continuity in California’s towns and cities. People who have owned a home for the long run are likely to have tax bills far lower than they’d have if they bought a different home and had to pay the full tax assessment, which creates a lock-in effect.
Prop 13 was passed in 1978, and between 1970 and 2000, the average period of ownership for California properties rose by 1.04 years.
Low Housing Inventory and High Prices
A dip in housing inventory can contribute to the lock-in effect and become self-reinforcing.
Homeowners who sell their homes still need a place to live. People frequently sell their homes and use the proceeds to buy a new property. If there aren’t enough homes on the market, it’s more difficult for someone to buy a new one, leaving them locked into their current property, thus making it difficult for yet another homeowner to find a home to buy.
The same is true if prices are too high. If someone can afford their housing payment but would struggle to afford a new home in their area, they could get locked into their property.
Impact of the Lock-in Effect on Housing Prices
Generally, the lock-in effect reduces home inventory, which can lead to a rise in housing prices.
In a more typical housing market, first-time buyers purchase less expensive starter homes from people who are upgrading to larger or more expensive homes as they age and, generally, their income grows. When fewer people are willing to sell, that makes it harder for first-time buyers to start up the property ladder and for existing homeowners to upgrade. With less supply, prices remain high.
Because of low supply and high prices, the lock-in effect weakens the market and slows down the rate of sales. Eventually, demand decreases as people get priced out of the housing market. If demand falls precipitously and supply again outpaces it, this should bring prices down. However, demand may simply fall to reach equilibrium with supply, which means prices will stabilize rather than fall.
Examples of the Lock-in Effect
For the housing market in 2023, about 92% of homeowners with a mortgage had an interest rate under 6%. That was more than 1% lower than the national average of 7.03%. In addition, 82.4% had a rate under 5%, 62% had a rate under 4%, and 23.5% had a rate under 3%.
When selling your home means taking on a mortgage that might more than double your interest rate, selling becomes far less appealing. That’s among the reasons existing home sales fell 17% in the year up to 2023.
The effect of Proposition 13 in California is a classic example used by researchers for the lock-in effect. The statute, passed by California voters in 1978, capped property tax increases for existing homeowners at 2% annually. Between 1975 and July 2023, the All Transactions House Price Index for homes across the U.S. rose by 994%. In California, the increase was 2,128%. The effect wasn’t just on owner-occupiers but also on renters in California: from 1970 to 2000, which includes the era of Proposition 13, the average tenure of California homeowners and renters increased by 1.04 and 0.79 years compared with homeowners in similar states and localities. These figures may appear small until one sees that they represent increases in average tenure of 10% and 19%, respectively. In other words, the lock-in effect in California may have contributed to its housing market seeing prices rise far more quickly than in the rest of the country.
Strategies to Mitigate the Lock-in Effect
For homeowners experiencing the lock-in effect, a few options are available to mitigate its impact.
One option is to account for future refinancing. Most mortgages have a repayment term of 30 years, which is long enough for interest rates to move in a lower direction. In the past 30 years, mortgage rates have increased, ranging between more than 9% and less than 3%. Buying a new home at a higher rate can be more expensive, but it’s possible to refinance to a lower rate in the future if rates drop.
Homeowners may also consider taking advantage of high home prices to downsize or change to renting. If supply is limited and you can sell your home for an inflated price, it may be advantageous to do so and then reenter the market once the lock-in effect eases and supply increases. In most areas of the U.S., rent has risen more slowly than home-sale prices, making renting to live in more advantageous properties in the short- or medium-term potentially beneficial financially.
Outlook and Implications
One of the key contributors to look for when there’s a lock-in effect is rising interest rates. For example, the Federal Reserve spent much of the period from 2021 to early 2023 increasing the fed funds rate to fight inflation. If rate hikes were to resume, this could worsen the lock-in effect, constricting inventory further. Conversely, a rate cut could weaken the lock-in effect, which may increase supply and help reduce home prices.
For these reasons, existing home sales after 2023 should remain lower for a while. A report from Federal Home Loan Mortgage Corp. in July 2023 indicated that existing home sales had fallen 22.2% since the same time in 2022. However, new housing construction may add to the housing inventory. Housing starts increased by 21.7% in May 2023, and the National Association of Home Builders/Wells Fargo Housing Market Index builder confidence index rose significantly.
Overall, the outlook based on the above would be uncertain. Economic data in 2023 appeared strong. That could encourage the Fed to leave rates as they are, which could cause the lock-in effect to continue. If inflation rises, as some fear, rates could worsen the effect.
Meanwhile, if the economy were to slow and tip into recession, that would likely lead to rate cuts, weakening the lock-in effect. However, a slowing economy would also reduce housing demand.
Are There Regional Variations in the Lock-in Effect?
Yes, there are regional differences in the lock-in effect. A clear example of this is California’s Prop 13, which creates a unique disincentive toward selling in the state.
Can the Lock-in Effect Be Beneficial for Homeowners?
Yes, the lock-in effect can benefit homeowners in some ways. For example, the effect can limit housing supply and cause prices to rise, increasing homeowners’ equity. Homeowners who wish to use that equity, such as by getting a home-equity loan or line of credit, may benefit from being able to borrow more. Another benefit is that the communities are more stable if homeowners and renters are less likely to be moving in and out of them.
What Are the Risks of Refinancing To Mitigate the Lock-in Effect?
Refinancing as a strategy to mitigate the lock-in effect isn’t perfect. One downside is that rates may stay persistently high, meaning you won’t be able to refinance to a lower rate to save money. Additionally, refinancing ordinarily involves extending the term of the loan, which means it will take longer to repay the debt.
What Are Other Reasons for Dips in the Housing Supply?
The lock-in effect is just one reason there isn’t much supply in the housing market. Another is that the population of the U.S. has increased significantly. From 1990 to the early 2020s, the population increased from 248 million to 331 million. The housing market has to support 83 million more people than it did about 30 years ago.
Housing construction also fell significantly in the wake of the 2008 financial crisis. In 2007, 1.5 million homes were built; in 2009 that number fell in half to 794,400. The pace of construction has still not returned to pre-2008 levels, sitting at 1.39 million as of the last data available in 2022.
Will the Housing Market Crash in 2024?
Predicting the future of the housing market is difficult. If rates continue to rise, the lock-in effect could worsen, reducing supply and keeping prices high. However, if the economy enters recession, it could force homeowners to sell, which could lead to a decline in housing prices.
The Bottom Line
The lock-in effect occurs when homeowners who otherwise might sell their homes don’t do so. Whether the reason is rising interest rates, changes in laws or regulations, or something else, if people are locked into their existing properties, this can reduce the housing supply and lead to a difficult market for buyers.