Monday, August 23, 2010

The Importance of Mortgage Rates

The Washington Post details how low current mortgage rates are:

Mortgage rates fell this week to the latest in a series of record lows amid concerns about the state of the U.S. economy, according to a survey released Thursday by Freddie Mac.

Interest rates on 30-year fixed-rate mortgages, the most widely used loan, averaged 4.42 percent this week, down from last week's 4.44 percent and its year-ago level of 5.12 percent, according to the survey.

Thirty-year mortgage rates have fallen to record lows for nine straight weeks. Freddie Mac started the survey in April 1971.

And the corresponding chart...

In my opinion, rates (and only rates) are the reason why there has been a (temporary?) halt in housing price declines. Housing values were (and I believe are) too high, but low nominal rates have made monthly payments much more affordable.

The chart below shows the monthly mortgage payment for a $200,000 house after a 20% down payment (i.e. a $160,000 mortgage) using the above 30-year mortgage rates.

Current monthly payments on a $160,000 mortgage are only $803, down from more than $1000 in October 2008. In other words, monthly payments are down 20% even if the price of the house didn't drop over that period.

The important question is what can happen from here?

While I am not claiming that prices will fall off another cliff soon, there is a significant risk of a further decline... especially if rates don't stay this low (for this reason I do expect rates to stay this low). The below chart keeps the current $803 monthly payment constant, but backs into what the value of a home using historical mortgage rates would have been for monthly payments to stay at that $803 level.

What does this mean for anyone looking to buy a house?

Since the key contributor to housing affordability is not the current list price, but rather the mortgage rate, anyone looking to buy should seriously consider the alternative (i.e. renting) if they don't plan to use that contributing factor (again... the mortgage rate) for the life of the loan (i.e. to keep their house for 15-30 years).

If you do plan to buy a house for a smaller window of time (i.e. 1-10 years) with the idea of flipping it into a larger house, be careful. That $803 per month clearing price may mean a much lower home value when you are trying to sell...

Update:

An anonymous reader makes a common mistake in questioning the details of the post:

If you're planning to swap out your house after a couple of years for a bigger house, wouldn't you want house prices to come down? Yes, you'd lose money when you sell your old house, but you'd save even more money on the larger house, whose price also went down.

This would be true is there was no leverage (i.e. financing) involved or if the decline occurred in combination with a further decline in rates. My concern is that a rise in rates will coincide with or even trigger the next price decline. As a result, a decline in the value of homes could be disastrous (remember, investments in housing typically involve a ton of leverage).

My response (slightly edited):

Not if housing prices decline due to a rise in mortgage rates, which would result in a unchanged monthly payment on the new property (i.e. home price drop is exactly offset by mortgage rate rise = no impact on the mortgage payment).

The reader used an 'extreme' example of a $100k house flipped into a $1mm house, which I will replicate:

  • $100k mortgage = $500 / month mortgage payment at current rates
  • $1mm mortgage = $5000 / month mortgage payment at current rates

Now, assume home values drop 10% due to a rise in rates, which would happen all else equal if homes were strictly based on monthly payments individuals could afford and rates rose to 5.32% (monthly payments on a $90k loan at 5.32% = ~$500, which is the same as a $100k loan at 4.4% = ~$500)

Outcome:

  1. $100k home is now worth $90k (you lose $10k)
  2. your monthly payment on the new $900k mortgage is the same as it would have been previously on a $1mm mortgage (~$5000 per month)

As you can see, the owner doesn't get the benefit of the price decline if they need financing to own. The situation becomes dire in a move to a similarly priced home. Assuming a move from a $1mm house to an identical house now worth $900k.

  1. you lose $100k in equity
  2. your monthly payments are the same

If there is a larger price decline (one larger than the level of equity in a home), one can see how ugly this can get. Again, the reason being leverage and my concern that the only thing propping up the housing market is subsidized financing. My concern is that borrowers are buying what they can (barely) afford in terms of a monthly mortgage payment and not in terms of what they can afford in terms of price of a home relative to wealth.