The 'catastrophic' impact of a debt default on housing costs 

A potential debt default by the U.S. government that would cause a catastrophic rise in mortgage costs is already pushing interest rates up.

A default, which could happen as soon as June 1,  would pull the floor out from under the already struggling housing market and erase nearly a quarter of all sales by September, according to projections from Zillow.

And as negotiators from the Biden administration and Republican leaders in the House indicate that they remain far apart, mortgage rates are already inching upward.

"Several factors are affecting interest rates right now," said Dr. Paul Bishop, economist for T3 Sixty. (Note: T3 Sixty and Real Estate News share a founder, Stefan Swanepoel.) Uncertainty about the Fed's June decision on interest rates, along with the possibility of more regional bank failures, are playing into the mortgage rate rise.

"On top of that we have the debt ceiling negotiations which add an additional layer of concern," Bishop said. "Consequently, bond and equity markets are getting more skittish as the possibility of a debt default increases, which would likely lead to a deep recession."

Some perspective: The U.S. has never defaulted on its debt, and few expect Congress or the White House to let it happen now. But even getting this close to the deadline is starting to have an impact.

"Homebuyers looking for a mortgage right now can expect rates to stay roughly where they are now until there is more clarity and hopefully a resolution to the debt ceiling standoff in the next few days," Bishop said.

If the federal government does default, Zillow estimates mortgage rates could reach 8.4%, sending the monthly payment on a typical home 22% higher by September. That's on top of an 82% rise over the past two years.

And while buyers would be hammered by higher financing costs, they wouldn't get much help in the way of lower prices. Zillow projects low inventory to keep prices from falling too far or too fast under the default scenario.

"An outright debt default would be catastrophic for the economy and send mortgage rates skyward, not for a few days but perhaps for weeks," agreed Bishop.

"Worst of all, over the long term it's likely that rates would remain higher than they otherwise would be if global financial markets have doubts about the willingness of the U.S. government to pay its bills in full and on time," Bishop said.

Investors have confidence in Treasury bills because the U.S. has historically been rock-solid in paying its bills. A default would shake that confidence, and investors would demand higher returns to balance that higher risk. Since mortgage rates tend to follow Treasury rates, they would almost certainly also rise.

Dr. Bishop said that would lead to wide-scale slowdown. "A jump in mortgage rates would add to the numerous headwinds in the market, notably the affordability challenges of already-stretched home buyers, and a likely downshift in home sales in the coming months."  

Zillow Senior Economist Jeff Tucker is equally downbeat about the impact on the real estate market. "Home buyers and sellers finally have been adjusting to mortgage rates over 6% this spring, but a debt default could potentially raise borrowing costs even higher and send the market into a deep freeze," Jeff Tucker said. "Home values might not see a notable drop, but higher mortgage rates would severely impair affordability, for first-time buyers especially."

The Zillow analysis notes that higher mortgage rates may further discourage homeowners — many of whom are sitting on mortgages at much lower rates — from selling. As a result, home values would begin to fall starting in August, but only by 1% from current levels. In the case of a default by the U.S. government, Zillow forecasts home values to rise 1% from today to the end of next year, down from a current expected rise of 6.5%.