Middle class homebuyers are taking on $7,000 mortgages with plans to later refinance down

In December 2021, when the 30-year fixed mortgage rate still averaged 3.1%, a borrower could get $700,000 mortgage that required monthly payments of principal and interest of just $2,989.

Fast-forward to Wednesday, and a $700,000 mortgage taken out at the current average mortgage rate of 6.90% would equal a $4,610 per month payment, which is $583,000 more over 30 years than that mortgage issued at a 3.1% rate. When adding on insurance and taxes, that monthly payment could easily top $6,000. Not to mention, that calculation doesn’t account for the fact that U.S. home prices in June 2022 were 12% above December 2021 levels and 39% above June 2020 levels.

Mortgage planners like John Downs, a senior vice president at Vellum Mortgage, have the hard job of breaking this new reality to would-be homebuyers. However, unlike last year, Downs says most 2023 buyers aren’t surprised. The sticker shock, the loan officer says, is wearing off.

Just before speaking with Fortune, Downs wrapped up a call with a middle-class couple in the Washington D.C. area, who told him they were expecting a mortgage payment of around $7,000.

“The call I just had was a typical area household. One person makes $150,000, the other makes $120,000. So $270,000 total and they said a payment goal of $7,000. I’m still not used to hearing people say that out loud,” Downs says.

Even before these borrowers speak to Downs—who operates in the greater Baltimore and Washington D.C. markets—they’ve already concluded that these high mortgage payments will be “short-lived,” and they’ll simply refinance to a lower payment once mortgage rates, presumably, come down.

To better understand how homebuyers are reacting to deteriorated housing affordability (and scare inventory levels), Fortune interviewed Downs.

This conversation has been edited and condensed for clarity.

Fortune: Over the past year, mortgage rates have spiked from 3% to over 6%. How are buyers in your market reacting to those increased borrowing costs?

John Downs: I must say, the reaction today is quite different from last year. It’s almost as if we have lived through the “7 stages of grief.” We appear to have entered the “acceptance and hope” phase.

With all the reports pointing to home prices stabilizing, one might think that buyers are comfortable with these rates and corresponding mortgage payments. The reality is quite different. Many would-be homebuyers have been pushed out of the market due to affordability challenges through loan qualifications or personal budget restraints. Move-up buyers also find themselves in the same predicament.

As a result, my market (Baltimore-DC Metro Region) has 73% fewer available homes for sale than pre-pandemic, 57% fewer weekly contracts, and an 8% increase in properties being relisted. (Information per Altos Research) As a result, prices have remained relatively stable due to the balance of buyers outweighing sellers.

I’m seeing buyers today taking the payments in stride for various reasons. Their incomes have risen dramatically, upwards of 25-30% since 2020, and the income tax savings through the mortgage interest deduction is now a meaningful budget item to consider. Many also say, “I can always refinance when rates come down in the future,” which leads to a sense that this high payment will be short-lived.

When I say buyers are comfortable with these payments, I know there are also two to three times more buyers who run payments using online calculators who opt out of having conversations in the first place! To prove this, our pre-approval credit pulls (a measure of top-of-funnel buyer activity) are running about 50% lower than pre-pandemic.

Among the borrowers you’re working with, how high are monthly payments getting? And how do they react when you give them the number?

For the better part of the last decade, most of my clients would enter a pre-approval conversation with a mortgage payment limit of no more than $3,000 for a condo and $4,500 for single-family homes. It was rare to see numbers higher than that, even for my higher-income wage earners. Today, those numbers are $4,000 to $6,500 respectively.

To my earlier comment, active buyers today seem to expect it. It’s as if they are comfortable with this new normal. Surprisingly, the debt-to-income ratios of today (in my market) are very similar to where they were five years ago. Income is ultimately the great equalizer. Yes, the payments are dramatically higher today, but the buyers’ residual income (post-tax income minus debt) is still in a healthy range due to local wages.

Remember, we are still talking about a much smaller pool of buyers in the market today so this conversation is skewed towards those with more fortunate lifestyles.

Tell us a little bit more about what you saw in the second half of 2022 in your local housing market, and how that compares to the first half of 2023?

There are dramatic differences between those two periods. In the second half of 2022, there was nothing but fear. The stock market was under stress, inflation was running wild, and housing began to stall. Across the country, inventory began to rise, days-on-market pushed dramatically higher, and price decreases were rampant. The safest bet then was to do nothing, and that’s just what buyers did. The mindset was, “I will wait until prices fall and rates push lower before I buy.”

The start of 2023 sparked a reversal in many asset classes. The stock market found a footing and pushed higher, mortgage rates rebalanced, property sellers adjusted their prices, and employers began pushing out significant wage increases. As a result, housing stabilized, and in some areas, aggressive contracts with multiple offers, price escalations, and contingency waivers became the norm.

The strength in housing was not as universal as it was in 2021. There were very hot and cold segments, depending on location and price point. The affordable sector (<$750,000 in my market) and higher-end (>$1.25 million) seemed to perform very well with heightened competition. The mid-range segment is where we noticed some struggles. One common theme is that buyers at every price point seem much more sensitive to the property’s condition. When the housing payments are this elevated, it doesn’t take much for the buyers to walk away!

What do you make of the so-called “lock-in effect”— the idea that existing market churn will be constrained as folks refuse to give up those 2-handle and 3-handle mortgage rates?

I believe the “lock-in effect” is very real. My opinion is based on countless conversations I’ve had in the past 6-9 months with homeowners who want to move but can’t. Some cannot afford to buy their current home at today’s value and rate structure. Others just cannot stomach the significant jump in payment to justify the increase in home size or the preferred location.

I believe the reason we are seeing struggles in the mid-range home is that the traditional move-up buyer is stuck. In my market, that would be the person who sells the $700,000 home to purchase at $1 million. They currently have a PITI housing payment of $2,750; the new payment would be $6,000 rolling their equity as a down payment. That jump is too much for most, especially those with a median income. That payment would have been $4,500 a couple of years ago, which was much more manageable.

Based on what you’re seeing now, do you have any predictions on what the second half of 2023 might look like? And any thoughts on the spring of 2024?

Despite high rates, the desire to buy a home is still high for many. Given the lag effects of Fed tightening (raising interest rates) coupled with an overall improvement in inflation, one can assume mortgage rates have topped out and will continue to improve from here. Think of playing with a yo-yo on a down escalator, up-and-down movement but generally pushing lower. As rates improve, affordability and confidence will shift, bringing out more buyers and sellers.

I believe this will be supportive for home values and give buyers more choice as inventory increases. Keep in mind, most sellers become buyers, so the net impact on inventory will be negligible. Knowing that some sellers will keep their current home as a rental, one could argue that inventory will worsen. At least buyers will have more house options each week, a stark difference from today.

When discussing strength in housing, thinking through local dynamics is crucial. The DC Metro area has a diverse, stable job market which I do not see reversing if an economic slowdown occurs. We didn’t have a tremendous push towards short-term rentals as many other areas and the “work-from-home” (WFH) environment had most people stay within commuting distance to the cities.

One thing I expect is an unwinding of WFH in 2024. In fact, I’m already experiencing that. Many clients are being called back to the office, either through employer demands or fear they will be exposed to corporate downsizing efforts. As a result, I expect underperforming assets (D.C. condos and single-family rentals in transitional areas of the city) to catch a bid while single-family rentals in the commuting neighborhoods plateau from their record-setting appreciation over the past few years.

Housing market affordability (or better put the lack thereof) is at levels unseen since the peak of the housing bubble. Do you have any advice on how would-be buyers can ease that burden?

This may be the most complex question because everyone is at a different place in life. For the better part of the last 20 years, my consultation calls were 20 to 30 minutes long, and we could formulate a great plan. Today, that pushes over an hour and usually requires a detailed follow-up call. If I had to sum up all my conversations, I would say it comes down to forecasting life and patience.

Forecasting is a process where you map out life over the next two to three years—discussing job stability, income projections, saving and investment patterns, debts rolling off (or being added), kids, schools, tuition, etc. From there, talking about local market dynamics such as housing supply, population growth, and interest rate cycles and projections. This helps formulate a solid budget to use for a home purchase.

Patience can mean several things. For some, it means renting for a period of time to save more money or ride out periods of uncertainty. For others, it could be looking for the right sale price mix and seller concessions for rate buy-downs, closing costs, etc. Sometimes it means being patient with your desired location. Maybe you just can’t have that specific house in that specific area for a few years and settling for the next best location is good enough for now. Housing used to be a stepping stone for many but the low-rate environment of the past few years allowed everyone to get what they wanted right away. We seem to have lost the art of having patience in life.