The lock-in effect refers to the phenomenon where homeowners with existing mortgages at lower interest rates are hesitant to sell their homes and buy new ones at a much higher mortgage rate.
It makes sense.
While the average 30-year fixed mortgage rate was 7.17% on Monday, the effective mortgage rate on outstanding U.S. mortgages is 4.0%.
In other words, the typical mortgage borrower would exchange a 4.0% rate for a 7.17% mortgage rate if they were to sell and buy a different home today. That’s a hard sell.
The lock-in phenomenon was recently highlighted by researchers at the Federal Housing Finance Agency in a working paper titled, "The Lock-In Effect of Rising Mortgage Rate," published in March.
It found that rising mortgage rates have led to a staggering 1.3 million "lost" existing-home sales between Q2 2022 and Q4 2023. That includes 182,490 lost sales in California alone.
“In the United States, nearly all 50 million active mortgages have fixed rates, and most have interest rates far below prevailing market rates, creating a disincentive to sell," the FHFA researchers noted.
"This paper finds that for every percentage point that market mortgage rates exceed the origination interest rate, the probability of sale is decreased by 18.1%.
"This mortgage rate lock-in led to a 57% reduction in home sales with fixed-rate mortgages in 2023Q4 and prevented 1.33 million sales between 2022Q2 and 2023Q4.”
Switching from a lower mortgage rate to a higher one can lead to significantly increased monthly payments. For many homeowners, the cost of selling their current home and purchasing a new one with a higher mortgage rate is financially unfeasible.
What could ease the lock-in effect going forward?
- Life events: Over time, life events such as having an additional child or receiving a big promotion might prompt homeowners to sell their current homes and move, despite their ultralow mortgage rates. These personal changes could outweigh the financial disincentives for some.
- Falling mortgage rates: If mortgage rates decrease, improved affordability could entice more homeowners to sell and buy new homes. While homeowners might not trade in their 4.0% mortgage rate for a 7.0% rate, they might consider moving if it means taking on, say, a 5.5% mortgage rate. This reduction in rates, if it occurs, could lower the switching cost and make moving a more viable option.
And odds are, the lock-in effect could take years to fade away.
"Mortgage rate trends aren't likely to bust the lock-in effect until at least the end of the year, and possibly well into 2025, as the Fed holds fast on fighting inflation," predicts Realtor.com senior economist Ralph McLaughlin.
"We'll likely need to see a 150 to 200 basis points drop in the 10-year yield to get there, and at current spreads, this could require three to four rate cuts by the Fed. As of now, the market is pricing in just one to two cuts by the end of the year and two to three cuts in 2025," he adds.
"As such, anyone hoping the lock-in effect will be busted this year may be sorely disappointed."
