The Federal Reserve’s effort to contain inflation is making it more difficult for lower-income Americans to buy a house, according to experts and a recent study.
The share of home loans taken out by low-income borrowers falls by 16% when interest rates rise by one percentage point, according to a Federal Reserve Board working paper published earlier this year. Under the same rate environment, the percentage of purchase mortgages going to both moderate- and low-income borrowers drops by 7.5%.
The decline lasts for a year, the paper found, and is especially pronounced among first-time homebuyers.
Getting shut out of homeownership can hurt many low-income households’ long-term financial prospects because home equity wealth can be used for retirement, funding education, or financing a small business among other opportunities.
"You are not just building wealth," John Sabelhaus, a fellow at Brookings Institution and former chief of microeconomic surveys section at the Federal Reserve Board, told Yahoo Finance. "You are buying an insurance policy that says I've got a place to live for the rest of my life."
‘Making it dismal for folks’
The research comes as the Federal Reserve continues its fight against inflation by raising its benchmark interest rate. Last week, the central bank hiked the rate by a quarter-point and has increased the rate 4.75 percentage points since March 2022.
The yield on the 10-year Treasury — which fixed mortgage rates tend to track — have increased as a result. The average rate on the 30-year fixed-rate mortgage, the most popular home purchase loan, has followed, oscillating between 6% and 7% for months. The rate borrowers with smaller down payments, blemished credit scores, or higher debt can qualify for is likely higher.
"A volatile interest rate of over 7% is totally making it dismal for folks in terms of home buying," Ibijoke Akinbowale, community impact director at National Community Reinvestment Coalition, told Yahoo Finance.
Although the recent interest rate hikes affect all homebuyers who require financing, lower-income households are especially vulnerable because banks use the debt-to-income, or DTI, ratio as part of the underwriting process to qualify borrowers for loans.
"... these households' budgets are tighter and they more frequently come up against binding payment-to-income ratio constraints in credit decisions." Daniel Ringo, the Fed researcher, wrote. “If rates rose, their resulting DTI ratio may be too high to qualify for credit."
The DTI ratio is a borrower’s monthly debt obligations divided by their income expressed as a percentage.
For instance, if a borrower earns $5,000 a month before taxes and must pay $1,500 for their hypothetical mortgage, $250 for a car payment, and another $300 for their credit card payments, that borrower’s debt-to-income ratio is calculated by dividing $2,050 (total debt) by $5,000 (income), which is 0.41, or 41%.
In general, borrowers with a DTI in the low 40s can qualify for a mortgage.
“Depending on the lender and the loan choice, for most borrowers, 43% is a good working max cap for the [debt-to-income] ratio,” Keith Gumbinger, vice president of HSH.com, a mortgage resource website, wrote to Yahoo Finance.
As mortgage rates rise, so does the hypothetical mortgage payment in the DTI equation, which would increase the DTI percentage — in some cases, beyond that 43% threshold. Lower-income borrowers are more susceptible to that outcome because the income side of the DTI equation is lower.
"When you have interest rates as high as they are, that difference of a monthly payment of $300 to $400 a month has now totally boxed [lower-income families] out of being able to qualify for any of the affordable properties that were within their range," Akinbowale said.
Not just financial security, but opportunities
A home provides not just a roof over a family’s head, but also financial opportunities down the road.
Homeowners can tap into their home equity to access cash to pay for home improvements, medical emergencies, tuition, or business expenses. It can be a cheaper way to borrow significant amounts of money than borrowing through credit cards or personal loans. A homeowner can also cash out their equity for retirement savings by downsizing to a smaller home when they’re older or use a reverse mortgage to receive monthly equity payments.
"People when they start small businesses, they leverage the funding to be able to start these businesses [through] their home," Akinbowale said, "so you're talking about generations that have been locked out of pursuing homeownership, locked out of the financial process and systems itself."
The difference in financial opportunities can be vast. The net worth of homeowners is 40 times higher than renters. In 2019, the median net worth of homeowners was $255,000, versus $6,300 for renters, according to the Federal Reserve.
Home equity has only grown since. Year over year, national homeowner equity increased by $1 trillion, or 7.3%, in the fourth quarter of 2022, according to Corelogic.
"Once you are buying a home, most homes traditionally have not declined in value," Andy Winkler, director of housing and infrastructure at Bipartisan Policy Center, said. "And in particular, [in] the last couple of years, people who owned a home saw a really significant gain in their equity."
‘Housing market was collateral damage’
The Federal Reserve is unlikely to stop hiking its benchmark rate until inflation is under control, meaning lower-income buyers remain at a disadvantage.
“They don't have additional tools at their disposal to fight inflation,” Winkler said of the Fed. “Unfortunately, like the Fed Chair said, the housing market was collateral damage."
However, housing experts believe certain policies could be developed in this environment to help these families become homeowners.
“Programs focused on subsidizing interest rates for lower-income borrowers could reliably
increase their home purchase borrowing,” Ringo wrote in his research paper.
Sabelhaus offered a similar solution by creating a “program that would provide a form of insurance so that a bank could issue a mortgage to somebody who would appear too risky under the current guidelines.”
In addition, Akinbowale said rental history could be used to help lower-income families qualify for mortgages along with advocating policies that help communities hurt most by higher mortgage-rate environments.
“We need collaboration both federally and privately,” Akinbowale said, “in order to make funding resources reach the consumers within marginalized groups that have been traditionally locked out of the home-buying process.”
Gabriella Cruz-Martinez contributed to this report.
Rebecca is a reporter for Yahoo Finance and previously worked as an investment tax certified public accountant (CPA).
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