May312016

## Mortgage interest rates strongly impact homeownership costs

##### Low or falling mortgage interest rates are better for housing costs than high or rising rates.

From a consumers point of view, higher interest rates are bad because borrowing money becomes more expensive. All things being equal, higher mortgage interest rates make for a higher cost of ownership and visa versa. When potential homebuyers actively look to purchase a home, shopping around for the lowest rate can save them thousands of dollars over the life of the loan. The Consumer Financial Protection Bureau launched a Rate Checker to help consumers verify if the rate they are quoted is good or not.

Since rising mortgage interest rates raises borrowing costs, it’s also detrimental to home prices, so nobody in real estate relishes the idea of higher mortgage interest rates.

In a previous post I discussed the four variables that determine the purchase price of a property:

- borrower income,
- allowable debt-to-income ratios,
- interest rates, and
- down payment requirements.

Today we look at interest rates.

Interest rates are the yield on debt instruments. If investors lose their appetite for mortgage debt, prices of mortgage-backed securities go down, payment yields go up, and mortgage interest rates go up with them. The Federal Reserve heavily influences the yield investors require by adjusting the Federal Funds Rate, the base rate all yields are compared to.

### Interest Rates have a major impact on loan balances

Mortgage interest rates determine how much someone can borrow to buy a house. The same payment at different interest rates produces significantly different loan balances. When lenders calculate the size of the mortgage a borrower can sustain, they plug in the interest rate and the maximum payment (calculated by applying maximum debt-to-income ratio to gross income).

For example, if a borrower makes $100,000 per year, the lender will allow them a maximum yearly debt-service of 31%, or $31,000. Divide that by 12 to get $2,583,33. Some amount is taken out for taxes, insurance, and HOAs leaving a remainder amount to cover a mortgage payment. The lender then takes that payment amount and plugs it into a formula to determine the maximum loan balance. At low interest rates, this amount is quite large, and at high interest rates, the supportable mortgage balance is much smaller.

Back in 2006 house prices were inflated because nobody could afford them using stable, conventional financing. Through buying mortgage-backed securities, the federal reserve worked to bring mortgage interest rates down from 6.5% to 3.5%, which made the insane prices of 2006 attainable in 2016 despite weak wage growth. Such is the power of low mortgage rates.

### What happens when interest rates rise?

Many people fear that mortgage interest rates will rise back to historic norms of 8% or go even higher, although I posit that we’ve reached a permanently low floor in mortgage interest rates. Higher mortgage interest rates decrease the size of loan balances — that’s the inescapable math. If this were not true, the federal reserve wouldn’t have purchased mortgage-backed securities to lower interest rates.

At today’s 4% interest rates, borrowers comfortably leverage over five-times their yearly income. The long-term average for interest rates is 7%-8%; at those interest rates, borrowers only leverage three-times their yearly income. The old rules-of-thumb about borrowing three-times income are relics of a bygone era. But what happens if those interest rates come back? Four percent interest rates are not a birthright; in fact, interest rates have only been this low one other time in the last two hundred and twenty-six years.

As is evident in the very long term chart of interest rates above, the interest rate cycle is very long. During the cycle of rising interest rates, central bankers raise interest rates to combat inflation and protect the value of the currency, but they are always one step behind. Janet Yellen finally embarked on the next multi-decade rising cycle where inflation is a constant problem. We are early in the new up-cycle, so inflation is not a problem yet, but it will be.

### Will rising interest rates be offset by rising wages?

If wages rise as fast as interest rates do, then borrowers will still be able to finance large sums, and house prices can remain stable or even rise. However, if wages do not rise as interest rates go up, then loan balances will decline, and house prices may fall again. Given the choice between inflation and falling house prices, which do you think Yellen will chose?

Appreciation doesn’t happen by magic. House prices must be bid up by future buyers, and based on the conditions I see, now that the market is no longer undervalued and resting at a new equilibrium, future home price appreciation will be tepid at best.

## Low house prices or low mortgage rates?

Whether low house prices or low interest rates are better is a matter of perspective. From a lender’s point of view today, low mortgage rates and high prices are better because with so many borrowers still underwater around the country, lenders face future losses if house prices are lower than the outstanding loan balances from the bubble. Historically, lenders prefer higher rates because interest is income, and they would rather make a higher rate of return by charging a higher interest rate, but the problem with underwater borrowers shifted their preference.

From the perspective of taxing authorities, lower mortgage rates and higher prices are always more desirable. Municipalities obtain their revenues from property taxes, so they want land values as high as possible. Proposition 13 was supposed to prevent State and local governments from taxing people out of their homes, but instead Proposition 13 prompts lawmakers to support policies that inflate house prices as much as possible to regain the lost tax revenue — the opposite of what supporters of Proposition 13 wanted.

Most economists erroneously argue in favor of lower interest rates generally as a stimulus to the economy; however, low interest rates cuts both ways because the interest cost to a borrower is income to a lender. The federal reserve’s zero interest-rate policy has crushed seniors living on fixed incomes. The federal reserve’s policy steals money away from seniors, preventing them from spending this money on goods and services. Instead the federal reserve diverts the income to seniors on their savings to bail out loanowners who enjoy a debt-service subsidy and the foolish banks that loaned the money in the first place. Where is the economic benefit in that?

So that opens the larger question about which is better, lower prices or lower interest rates? Both lower the monthly cost of ownership and result in more disposable income. Obviously, the banks prefer higher prices to recoup their capital from their bad bubble-era loans, so they are offering 4% interest rates to prevent prices from going any lower. I think most buyers would prefer lower prices, but since the banks make the rules which determine market prices, low interest rates and high prices are what we get.

From a homebuyers perspective low rates or low prices depends on how they acquire the property. All-cash buyers would far prefer lower prices because they gain nothing from cheap debt they don’t use. From a financed buyer’s perspective, lower interest rates are better even if they pay higher prices.

If a financed buyer holds a property for 30 years and pays off the debt, how they financed the property doesn’t matter; however, if they sell the property before paying it off entirely, **low mortgage rates are superior because they amortize faster**. Assuming equal rates of appreciation during the holding period, a financed buyer using a low mortgage rate will accumulate more equity than a buyer who pays a higher mortgage interest rate; that’s the math. The key question is whether or not appreciation rates would be the same.

Buyers who purchase during a period of high mortgage rates may get the boost in appreciation from declining rates, so they may enjoy more appreciation than a financed buyer who buys today when mortgage rates are low. Over the last 30 years, declining mortgage interest rates added significant appreciation above and beyond the growth in income. The current generation of buyers won’t get the same boost.

**Low mortgage rates build equity faster through amortization but slower by appreciation. High mortgage rates build equity faster by appreciation but slower through amortization.**

Which do you think is better?

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