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...


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)


  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.


  1. 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.

    An extreme example is to compare a $ 100,000 and a $ 1,000,000 home. Right now the price difference would be $ 900,000 if you wanted to trade up. However, if both homes then declined by 90 % in price, the price difference would shrink to $ 90,000.

  2. not if the price of a home declines due to rising interest rates (thus monthly payment remain the same). in this example, you do not want prices to go down even if trading up to a higher priced home.

    why? because you lose equity value on the home you sell and monthly payments don't change for the home you buy, even though it is cheaper.

    taking your extreme example. at today's interest rates, montly payments:

    $100k mortgage: $500 / month
    $1mm mortgage: $5000 / month

    home prices drop 10% (assuming that is what you meant vs 90%) because mortgage rates rise to 5.32% (monthly payments on a $90k loan at 5.32% = a $100k loan at 4.4% = ~$500).

    1) $100k home is now worth $90k (you lose $10k)
    2) your monthly payment on a new $1mm mortgage is still $5000 / month (i.e. you don't get the benefit of the price decline because the decline was due to rising rates)

    in a move to a similarly priced home, this is even worse. assuming you move from a $1mm house to an identical house.

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

    why? leverage. if you do not take out a loan there is no difference (and in the extreme case a benefit). the issue is the only thing propping up the housing market is subsidized financing for this leverage....

  3. What I want to know is how much of a percentage of median income a mortgage payment for a cookie cutter 4 bedroom 2.5 bath home has changed. I assume it's gone down, since houses have gotten bigger but most people still are current on their mortgages...

    Anyone know the particular metric I'm looking for?

  4. Instead of that chart you created showing what happens with monthly payments, why not take historical data on what really happened to home prices?

    If you did, you will find out that in nominal terms, home prices DID NOT go down when interest rates spiked in the early 1980s

    This is just King Co. (Seattle), but if you graph national data, you will see the same thing - rising interest rates did not lower home prices in nominal terms.

  5. There was also not a bubble that was being popped or subsidized mortgage rates being used to keep the bubble from completely collapsing. My argument is a 'what if' as we are in unprecedented times.

  6. Last point (I'll save the rest for a post). In the past rising rise (and higher monthly payments) were offset in part by inflation and higher wages. What happens this time if rates rise, but wages don't follow. Is that my baseline? No, but not unlikely.

  7. the Fed and our economic gurus created the housing bubble by continually attempting to stimulate demand through low rates, at great cost to the few "savers" and pensioners in the economy.

    and somehow "we can't understate the importance of low rates?" how bout trying a different play from the playbook and create some incentives for Americans to save and invest in something more productive than shelter (which we have in abundance)?????

  8. What about working out the "dividend" that comes from a house paid off. Such as paying off a 30 year in 10 years and staying another five. You can treat those extra five years as from payments saved as income, which can be quite a lot of cash in your pocket if you are careful. For instance, 5 years * 2000 payment is 120k. If you have a 300k loan @ 4.5% or so and pay off early (hitting the lottery?) would these numbers work out more in your favor assuming the same interest rate hike and drop in price? Maybe I'm not quite making myself clear, I hope I am. Basically, does the money saved from prepayment offset the loss in value? If so, how much, and how long would you have to stay in the house afterwards in order to get that benefit?

  9. If you have the cash, you are purely trying to arb to subsidized mortgage rate. I'm not worried about you when you try to move in 5 years.

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