In today’s ownership society, few investments have been so lucrative for so many as homeownership. Since 2001 extremely cheap mortgage rates have fueled a record-setting level of home sales.

Frenzied demand caused home prices to jump at rates not seen since the 1980s and generated 10% gains each year in housing wealth for many Americans, who quickly used refinancings or home-equity loans to convert some of the windfall into cash.

With millions of Americans still eager to get into the housing bonanza, it’s no wonder signs of overheating are popping up. At building sites from Florida to California, househunters stand in line just for the chance to buy a home. Investors are flipping properties almost overnight. For some lucky folks, home values have doubled in five years. And in early 2005 the boom was in full swing. New-home sales surprised many economists by jumping 9.4% in February, to an annual rate of 1.2 million. And starts rose to a yearly pace of 2.2 million in the month, a level not seen consistently since housing’s go-go 1970s.

But hold on. Despite February’s strong numbers, 2005 looks to be the year that housing finally cools off. Thanks to tighter monetary policy and a stronger-than-expected economy, mortgage rates are on the rise. In just six weeks, rates have jumped by almost half a percentage point, to over 6%, by Mar. 25. By 2006 they will likely hit 7%. As a result, economists surveyed by Blue Chip Economic Indicators see housing starts slipping by about 5% this year and more in 2006. Sales are likely to fall by the same amount. On a national level, home prices aren’t going to plunge — they just won’t rise very much. “Home prices will rust, not bust, for the next few years,” says Richard Berner, chief U.S. economist for Morgan Stanley (MWD ).

Housing’s slowdown will be relatively mild compared with past downturns, though there are pockets of froth. Why? It’s taking place at a time when the economy is expected to grow by over 3.5%. In the past 40 years, national new-home prices have fallen only twice, and both times were during a recession.

Besides the good job and income growth associated with a healthy economy, there are other compelling reasons that the market won’t soften too much. Baby boomers continue to fuel demand — especially for second homes — and immigrants are increasingly becoming first-time home buyers.

Even so, the new reality will have a big impact on homeowners who have begun to look at 10% annual gains in home values as a birthright. Consumers who made a habit of tapping into their home equity will find that their home is no longer a personal ATM. Anyone counting on continued home appreciation to fund their retirement or pay for their children’s education may face a big shortfall when the bills come due. The new ways that housing is financed also shift the risk of rate changes from banks to homeowners. That could squeeze some families who have adjustable-rate mortgages.

For the economy, a slowdown in home demand and prices could crimp consumer spending. In just three years, from 2002 to 2004, homeowners who refinanced their mortgages took out a phenomenal $400 billion in extra cash, most of which was pumped back into the economy. That source is going to dry up. The loss will come on top of the eventual softening in construction activity and mortgage lending, both big sources of employment in this expansion.

A cooler housing market could even have an impact on the ability of the U.S. to finance its enormous current account deficit. Since 2000 foreign investors have poured $400 billion to $500 billion into mortgage-backed securities, which seemed safe and attractive. But that money could go elsewhere if the U.S. housing market turns sluggish and fewer mortgages are written.

Of course, predictions that housing is about to peak have been made repeatedly over the past few years. So why does the turn look certain now? “The slowdown is all because of higher rates,” says David A. Lereah, chief economist at the National Association of Realtors. True, mortgage rates have bounced up before — most recently in the summer of 2004 — but this time economists expect them to keep rising, in part because of the stronger economy. Plus, inflation has picked up, and not just from higher oil prices. In its last survey of regional business activity, the Federal Reserve found that “a number of districts indicated greater ease in passing along price increases.”

Higher borrowing costs are already pricing potential home buyers out of the market. In housing, affordability is determined by monthly payments, including taxes and insurance. Take a home buyer with an income of $100,000 and a $40,000 downpayment. At a 30-year fixed-mortgage rate of 5%, the buyer can bid as much as $421,000 for a home. At a 6% mortgage, that falls to $390,000. At 7%, the upper limit is only $362,500. Spread across all income levels, that 13% drop in affordability whittles away at demand and cuts down on bidding wars, which helped drive big price leaps in some areas.

As higher rates dampen demand, the effects will spread to the rest of the economy. In the past three years homebuilding has made an oversize contribution to the growth of real gross domestic product and employment. Residential construction makes up less than 5% of the U.S. economy but accounted for over 12% of average yearly growth since 2002. Similarly, construction jobs tally just over 5% of all payrolls, but hiring at building sites has accounted for 16.6% of all new jobs in the past two years.

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