There are two schools of thought here. One is that when the economy heats up, inflation kicks in, mortgage rates for new homes rise, the cost of building increases, and rents go up. Naturally, home prices go up as well. It makes sense for a couple of reasons -- first, if it costs more to build new homes, builders will need to raise prices to earn a living. If there is no demand for new homes at higher prices, they will not be built. This would effectively shrink the supply, which would then cause prices to increase. This ebb and flow is what keeps housing markets in balance.

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However, there is another theory: that when mortgage rates increase, housing becomes less affordable, so prices come down. This can be illustrated with an example. Say a town's average household income is $66,000 per year. Assuming that 31 percent of their income could be used for housing costs, that gives you $20,460 per year for housing, or an average of $1,705 per month. If $205 per month goes for taxes and insurance (a fairly conservative number), that leaves $1,500 a month for principal and interest. Here's what an increase in mortgage rates does to the amount you can afford to finance:

Payment Rate Loan Amt House Price (10% Down)

$1,500 4.00% $314,192 $349,102

$1,500 4.50% $296,042 $328,935

$1,500 5.00% $279,422 $310,469

$1,500 5.50% $264,183 $293,536

$1,500 6.00% $250,187 $277,986

$1,500 6.50% $237,316 $263,685

$1,500 7.00% $225,461 $250,513

$1,500 7.50% $214,526 $238,363

$1,500 8.00% $204,425 $227,139

According to this theory, if people can only afford $227,139 for homes, the price will need to come down or the homes won't sell.

Other factors: Unlike the supply of money and other commodities, the supply of homes and the price of property does not change instantly in response to movements in financial markets. It can take years for a developer to get permits, arrange financing, and build before new homes affect the supply and pricing in a given area. Sellers of existing homes don't just leave them up for sale in bad markets; they frequently withdraw them (lowering the supply) until prices come back to acceptable levels.

The type of financial products available affects demand and home prices as well. For example, many say that part of the cause of the housing crisis was lenders offering bad credit mortgages at near-prime teaser rates, which then increased. Other products that artificially made higher priced homes more affordable were pay-option ARMs, which allowed buyers to make payments based on 1% mortgage rates, and interest-only loans, which kept payments low in the initial years of home ownership. These products served to push home prices up when higher mortgage rates should have pressured them lower.

A group of economists determined that these factors cause mortgage-rate-related price changes to be delayed for 2.5 to 3 years after rate increases, and that if mortgage rates increased to 7.5 ercent, over three years we could expect a 13 percent decrease in property prices.

Does this mean that real estate prices are destined to come down?

Not exactly. Prices are already increasing in some of the areas most devastated by the foreclosure crisis (mostly in California). While overall trends may be easy to discern, the most important thing is that real estate is local -- national prices mean nothing to most buyers; their concern is what is happening in their neighborhood, and economists are a lot less successful predicting local trends.