Feb282014
Higher mortgage interest rates lead to lower sales or lower prices
In the absence of rising wages, when mortgage interest rates go up, one of two things will happen: either sales will fall, or prices will fall. Since we don’t have a free market in housing, sales will fall and remain depressed for a very long time.
Assuming a consistent payment, higher mortgage rates decrease the size of the loan and reduce the amount borrowers can bid on real estate. While it is possible the federal reserve may print enough money to spark wage inflation, given the high levels of residual unemployment and a low labor participation rate, wage inflation is a long way off, almost certain to come later than rising mortgage rates. Therefore, if rising mortgage rates results in smaller loan balances, then either sales volumes will go down, or house prices will go down, or perhaps some combination of both. This isn’t speculation; it’s basic math.
So which outcome seems more likely? If we had a free market without government and lender manipulation, prices would fall, perhaps precipitously depending on the market; however, we don’t have a free market, and our government, federal reserve, and a cartel of too-big-too-fail lenders are manipulating the housing market in an effort to drive up house prices. Since must-sell shadow inventory morphed into can’t-sell cloud inventory, I think it likely that home sales will be depressed for several years. If we had cleared the market, hedge funds and other investors would have purchased millions of homes, and sales volumes would have been much higher. Of course, this would have bankrupted the banks, so another path was taken, but this path has consequences. If the plan is to sell these homes to owner-occupants and higher prices — a group struggling with high unemployment, low savings, high debt levels, and poor credit scores — then it’s going to be a long, slow slog.
Why Higher Interest Rates Could Depress Housing Turnover
By Nick Timiraos, 10:34 am Feb 26, 2014
Record declines in home prices are a big reason housing turnover has been so muted in recent years, but low interest rates could serve as an additional — and underappreciated — contributor to the depressed level of homes being offered for sale, according to a forthcoming paper from researchers at DePaul University.
As interest rates begin to rise from their record lows of the past two years, more homeowners with a 3.5% rate will find it less appealing to sell their home when faced with buying their next one at, say, a 5.5% or 6% rate.
This isn’t a matter of “appeal,” it’s a matter of affordability.
There are a number of hidden assumptions in the study’s authors’ conclusions. First, the authors assume a person currently borrowing at 3.5% can afford to borrow the same amount at 5.5%. Since most people borrow the max when buying a house (at least in California), then if mortgage rates rise to 5.5%, they won’t be able to borrow near as much money. Assuming prices remain constant, they simply won’t be able to afford to buy another home — which leads to the second hidden assumption, house prices will remain constant.
If mortgage interest rates rise to 5.5%, future buyers won’t be able to finance such large loans; therefore, they won’t be able to buy out today’s buyers allowing them to make a move-up purchase, or if they do execute a sale, it will be at a lower price, and the owner will obtain less equity (or none at all). Without the additional equity from a future sale, the people who own today won’t be able to leverage into a move-up home tomorrow at higher interest rates.
The authors of this study ignore these hidden assumptions and assume future buyers are motivated by the “appeal” of these additional costs without examining the hard facts about equity and leverage and how affordability limits sales.
Millions of homeowners could face so-called “lock in” from low interest rates, especially if rates rise sharply in the coming years, potentially curbing housing demand.
The American economy remains particularly exposed to this risk because of the popularity of fixed-rate mortgages, which also shield borrowers, of course, from higher payments during a rising interest rate environment.
The fact that so many borrowers used fixed-rate mortgages is the only reason these properties won’t be forced on the market in distressed sales. At least the owners with fixed-rate mortgages can afford their payments and stay put. The people borrowing with ARMs are the ones who will find their house payments increasing so much they are forced to sell. Fixed-rate mortgages contribute to the stability of the housing market by limiting distressed sales, and that’s a good thing.
The potential for lock-in arises because homeowners that refinanced at ultralow interest rates face a “higher payment on the same mortgage amount,” says Geoff Smith, director of the Institute for Housing Studies at DePaul University in Chicago. “You’d think that would be a disincentive to trade up or to move in some cases.”
It’s more than a disincentive, it will make the future sale and repurchase unattainable.
DePaul researchers Patric Hendershott, Jin Man Lee and James Shilling looked at mortgages outstanding between 2005 to 2011 in Cook County, Ill., which includes Chicago. Their simulation modeled a one percent increase in interest rates in each of the coming three years, along with a 10% increase in home prices.
The two assumptions can’t happen together: if interest rates to up significantly, prices won’t also go up unless incomes rise rapidly allowing borrowers to finance larger sums, and rapid wage increases simply isn’t going to happen.
The result? Even though rising prices will free more “underwater” homeowners, or those who owe more than their homes are worth, to list their homes for sale, it wouldn’t be enough to offset the potential number of households who don’t want to sell because they’d have to trade up to a much higher interest rate.
The research found that a three percentage point increase in rates over three years would reduce housing turnover by 75%….
This is probably true, but not for the reasons they suggest. Again, this has nothing to do with choice or reluctance; if interest rates moved up that much, prices would not be affordable. Period.
Because interest rates have mostly drifted lower over the past 30 years, the U.S. economy doesn’t have any recent experience with the potential side-effect of rate lock-in. But research indicates that when rates on the 30-year fixed-rate mortgage rose from 10.1% to 17.8% between 1978 and 1981, household mobility fell 15% for every two percentage point increase in rates, according to research published by John M. Quigley of the University of California, Berkeley.
This has nothing to do with the potential side-effects of rate lock-in. The problem is and always was affordability, and the long-term decline in mortgage rates has artificially improved affordability. (See: Housing market impact of 25 years of falling mortgage interest rates)
For example, the average monthly interest rate from 1993 to 1999 was 7.63%. The average monthly cost of ownership was $1,538. That combination would finance a loan of $223,011. Add a 20% down payment, and the home price would be about $275,000 ($278,763 to be exact). Over the last 12 months, the median monthly cost of ownership in OC was $2,102. If you plug in that number in place of the $1,538 from 1993-1999, the resulting home price would be $380,089. The last reported median home price for OC was just over $500,000. House prices have been boosted about 30% due purely to the decline of interest rates from the mid 90s to today.
So now let’s assume mortgage rates will revert to the mean. What will a long-term rise in interest rates do to home prices? Interest rates must rise from about 4.5% to 7% to reach historic norms. If this happens over a 7 year period — which is a very gentle rise — rental parity will still fall from its current level even as rents and fundamental values rise. Since rental parity will serve as a more rigid ceiling on appreciation in the future, when prices rise beyond this barrier, it will serve as a major drag on appreciation.
In the absence of rising wages, when mortgage interest rates go up, one of two things will happen: either sales will fall, or prices will fall. Since we don’t have a free market, it seems more likely to me that sales will fall and remain depressed for a very long time.
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200 Basis Points, or just a 2% rise in mortgage rates, completely KILLS Orange County housing. And 400 Basis Points would completely bring this real estate market to a halt.
The FED is so desperate to keep this ponzi scheme going. Mortgage rates are the Fed’s primary concern, NOT inflation or unemployment.
I agree. They must keep mortgage interest rates low until wages begin rising, and even then they must not let mortgage rates rise too quickly.
Now that we have hit the ceiling of affordability, sales will be low, and appreciation, if it happens at all, will be tepid.
My impression is that it is actually worse than that, in that experiencing any real recovery is antithetical to keeping the banks solvent via the ZIRP strategy.
IOW, not only is the Fed’s primary concern to re-inflate the bubble via ZIRP, but having gone all-in on ZIRP, it is not interested in promoting a broad recovery, as that would make it all the harder to fight the natural market forces as required to maintain ZIRP.
In still other words, the Fed has taken the decision to throw a decade of economic growth under the bus as a necessary evil in order to save the banks.
Is this too cynical? Is it even possible to be too cynical where such ivory-tower types are concerned?
In as much as the federal reserve has allowed banks to keep bad debts on their books, the fed’s policies have contributed to slow economic growth. Ordinarily, banks would be required to write down their bad loans and liquidate the assets. This facilitates price discovery and frees up capital for more productive ends. Since that didn’t happen, we are bound to have a slow economy, just like Japan. The ZIRP in the US and Japan both were necessary to inflate asset values and allow banks to hope asset values collateralizing their bad loans would ultimately bail them out.
My impression is that it is actually worse than that, in that experiencing any real recovery is antithetical to keeping the banks solvent via the ZIRP strategy.
100% correct. Deleveraging and building savings are paramount to legitimate recovery. Without high interest rates, there is no correction thus no recovery.
There are other consequences to rising mortgage rates.
Wells Fargo Cuts 700 Mortgage Jobs
According to a report from The Charlotte Observer, Wells Fargo is laying off another 700 mortgage workers across the country. The bank announced Thursday the layoffs would affect mortgage processors and underwriters the hardest.
Charlotte, North Carolina serves as the East Coast regional headquarters for the San Francisco Bank, who previously cut workers in August, September, and October.
Total job losses this year have reached over 5,800 as rising interest rates have dramatically slowed the number of home refinancings.
Historically low interest rates pushed consumers towards refinancing, and as interest rates began to rise, refinancings cooled in the process. The extra staff once needed to process the influx of new refinancings are being let go.
The Charlotte Observer notes, “Wells Fargo’s mortgage banking income fell nearly 50 percent in the fourth quarter from the same period the year before, according to its most recent earnings report.”
Wells Fargo has considered lowering its credit requirements on home loans back to the subprime market to increase earnings.
Josh Dunn, Wells Fargo spokesman, said in a statement that the cuts were made to “better align with the market and increase the efficiency of our organization.”
Wells Fargo isn’t the only bank cutting staff—Bank of America recently cut 450 jobs from the bank’s West Coast offices and 280 workers from its St. Charles, Missouri office.
I will disagree with you. The Fed’s biggest priority is interest rate swaps.
It’s all related … all based on cheap money to protect legacy asset owners.
I hope you’re right, but I’m not so sure. As rates rise, so does the benefit of the mortgage interest deduction (more interest paid = larger deduction). This softens the blow of rising rates for higher-income taxpayers. If we’re talking about ~$800k mortgages for Irvine homes, then it’s fair to assume the borrowers’ income levels reach into the 33% IRS and 9.3% FTB brackets.
$800k fixed for 30 @:
1) 4.25% = $3,936 P&I
2) 6.25% = $4,926 P&I
However, considering the likely tax brackets in which these borrowers lie, the real payment might be:
1) $2,746 (~$1,190 benefit – 42.3% multiplied by initial monthly interest)
2) $3,176 (~$1,750 benefit – 42.3% multiplied by initial monthly interest)
So, a 200 bps rise in rates has an effective difference of $430 monthly on $800k financed. If we assume a maxed-out front-end DTI of 25%, that extra cost would require $1,720 more monthly income (or $20k annually).
Note: I’m not suggesting lenders qualify borrowers based on their effective payment considering the mortgage interest deduction. I’m suggesting borrowers at these levels consider the mortgage interest deduction when evaluating their personal monthly housing payment cap.
If we assume borrowers buying $1m Irvine homes have household incomes of $200k+ (a reasonable ratio), then a net $430 additional month cost will have some effect; but the question is, how negligible?
It initially and conclusively affects those who can qualify at $3,936, but not at anything above $3,937, and more folks affected are those who would have purchased the $3,936 qualifier’s home. And of course, there are those who produce their income from home sales, and home building.
Agreed. The only question is, how many borrowers in the $750k mortgage market are stretching lenders’ DTI limits?
All of them.
you’re grasping for straws.
the short term effects of rising rates on this hoax of a recovery completely dwarf the ‘effective difference on $800K financed’
The only way to raise the home ownership rate is to educate people on managing their finances. Since lenders just created a generation of Ponzis, the home ownership rate will remain below trend for many years.
CFPB Director Calls for Increased Financial Literacy
For Richard Cordray, the equation is simple: In the Land of the Free and the home of the free market, American citizens should be as informed about and capable of self-governance in their personal finances as they are in the democratic process, especially when it comes to borrowing for a mortgage.
In a speech Tuesday before the federal Financial Literacy and Education Commission, Cordray, the director of the U.S. Consumer Financial Protection Bureau (CFPB), urged the need for American businesses to teach employees the importance of saving and making more sound financial decisions when it comes to major investments, such as buying a home.
Cordray called upon business owners and managers to leverage such milestone moments in their employees’ lives to teach specific skills they will need in order to make good decisions for their future.
Cordray’s speech is the latest effort in a growing trend to help American citizens better understand what it means to borrow money to buy a home. Cordray said the lack of good consumer education was a key factor in the wave of foreclosures since the Great Recession started squeezing American throats five years ago.
He added that the CFPB fields daily calls from distressed homeowners watching their version of the American dream erode due to the poor decisions they’ve come to regret making.
Cordray’s challenge to American businesses builds on a January 27 report he made to the House Committee on Financial Services. In that speech, Cordray compared what he called “troubling similarities” between the student loan crisis plaguing young people and “the broken mortgage market before the crisis.”
The troubling similarities include borrowers who took out loans with much worse rates than they could have qualified for and the disastrous consequences of not knowing what kinds of questions to ask in order to secure more favorable loans.
Not all news from the CFPB camp is grim, however. Cordray said last month that the bureau’s efforts to educate Americans about the risks and consequences of their financial endeavors has yielded much fruit in the past two years. As more citizens become aware of the bureau’s education programs and consumer tools, he said, the more they have righted their troubled ships.
Still, Cordray says, there is much uneasy water to traverse. He called upon U.S. employers Tuesday to help employees understand and diversify their personal savings and to increase information about major financial decisions as well as increase access to information regarding employee retirement and benefits programs.
Only when the finances of American workers are in order, he said, are homebuyers in a true position to understand what getting a mortgage is all about.
Its common sense. Fools and their money….
They can start by educating people that a piece of dirt which does not generate any goods or services and only generates expenses like taxes and maintenance is not an investment.
That’s an uphill battle in California.
Dirt isn’t an investment, it’s a raw material that needs to be developed. Are you saying that there is no such thing as real estate development, or just that individuals buying homes should not consider their primary “roof over our heads” an investment?
I see a lot of all good or all bad approaches to real estate, but I think the reality is a little different. Buying a house in Irvine and hoping for appreciation is not an investment, but buying a plot of land to develop it with mixed use could be considered an investment. Maybe the difference is the plan to get a return – is it “sit and hope someone buys you out later for more than you paid, plus inflation”, or is it “I’m buying some land that I will develop and make a better use of this location, asset, etc”?
Real estate development which provides homes for purchase is providing a good and rental developments is providing a service. In both those cases it is an investment. The roof over ones head is not an investment it is consumption.
I agree with you, except I have narrowed down my definitions and expectations of results based on that definition. Farmland and commercial properties are investments, not always successful investments, but investments none the less. Residential real estate that one plans to live in with hopes for appreciation, is a speculation. Don’t get me wrong. I am not saying that investment real estate is more conservative or entails less risk than speculative real estate, but it may be important to know the difference in your mind in order to calculate reasonable expectations.
This is one of the reasons home sales will be lower in 2014.
Institutional Investor Sales Decline
RealtyTrac released its January 2014 Residential & Foreclosure Sales Report on Thursday, revealing institutional investors made up 5.2 percent of all U.S. residential property sales in January. Institutional investor sales are down from 7.9 percent in December, and down 8.2 percent from January, 2013.
The report clarifies that institutional investors are “defined as entities purchasing at least 10 properties in a calendar year.”
The January share of institutional investors was the lowest monthly level since March, 2012—a 22 month low.
Short-sales and foreclosure-related sales, “including both sales to third party buyers at the public foreclosure auction and sales of bank-owned properties,” combined for 17.5 percent of all U.S. residential shares in January, 2014, according to the company’s report.
All-cash sales increased to 44.4 percent, the seventh month above 35 percent.
“Many have anticipated that the large institutional investors backed by private equity would start winding down their purchases of homes to rent, and the January sales numbers provide early evidence this is happening,” said RealtyTrac VP, Daren Blomquist.
Metro areas with big drops in institutional investor share from a year ago included Cape Coral-Fort Myers, Florida (down 70 percent); Memphis, Tennessee (down 64 percent); Tucson, Arizona (down 59 percent); Tampa, Florida (down 48 percent); and Jacksonville, Florida (down 21 percent).
Counter to the national trend, 23 of the 101 metros analyzed in the report posted year-over-year gains in institutional investor share: Atlanta, Georgia (up 9 percent); Austin, Texas (up 162 percent); Denver, Colorado (up 21 percent); Cincinnati, Ohio (up 83 percent); Dallas, Texas (up 30 percent); and Raleigh, North Carolina (up 15 percent).
Blomquist continued, “It’s unlikely that this pullback in purchasing is weather-related given that there were increases in the institutional investor share of purchases in colder-weather markets such as Denver and Cincinnati, even while many warmer-weather markets in Florida and Arizona saw substantial decreases in the share of institutional investors from a year ago.”
Mortgage Rates Continue Rising
Mortgage interest rate readings came out mixed this week amid a pile of recent and upcoming economic reports.
Freddie Mac’s Primary Mortgage Market Survey, released Thursday, has fixed-rate mortgage (FRM) products rising over the week ending February 27, with the 30-year fixed coming up to 4.37 percent (0.7 point) from 4.33 percent previously. A year ago, the 30-year FRM averaged 3.51 percent.
The 15-year FRM this week shifted up similarly, landing at 3.39 percent (0.7 point) from 3.35 percent.
“Mortgage rates edged up with new home sales exceeding expectations and rising to a seasonally adjusted pace of 468,000 units in January, the strongest annual rate since July 2008,” said Frank Nothaft, chief economist and VP for Freddie Mac. “The S&P/Case-Shiller 20-city composite house price index rose 13.4 percent over the 12 months ending in December 2013.”
Adjustable rates in Freddie’s survey were down, meanwhile. According to the company, the 5-year Treasury-indexed hybrid adjustable-rate mortgage (ARM) averaged 3.05 percent (0.5 point) this week, down from 3.08 percent, while the 1-year ARM averaged 2.52 percent (0.4 point) from 2.57 percent.
At the same time, finance site Bankrate.com reported opposite movements in its own national survey: The 30-year fixed average moved down very slightly to 4.48 percent, while the 15-year fixed was down to 3.52 percent, the site reported.
At the same time, the 5/1 ARM shifted up slightly to 3.30 percent.
“Mortgage rates have been in a docile state over the past few weeks, as uncertainty regarding global markets has receded,” Bankrate said in its report. “While the pace of the U.S. economic recovery is still an open question, things have transitioned to a wait-and-see mode that translates into tame movements in mortgage rates.
“The surge of monthly economic releases over the next ten days may answer some of these economic questions, and be a catalyst for renewed volatility in the bond market, and ultimately, mortgage rates.”
Tax Reform Could Impact Housing Costs
The Chair of the House Ways and Means Committee wants to reform the monstrous tax code, but his comprehensive initial slate of ideas has people in the housing finance industry up in arms.
On Wednesday U.S. Rep. Dave Camp, R-Mich., unveiled his Tax Reform Act of 2014, which critics say could drastically increase taxes on homeowners and homebuyers, and which would levy a new lending tax on financial institutions.
“This legislation does not reflect ideas solely advanced by Democrats or ideas solely advanced by Republicans, nor is it limited to the halls of Congress,” Camp said. “Instead, this is a comprehensive plan that reflects input and ideas championed by Congress, the Administration and, most importantly, the American people. In other words, it recognizes that everyone is a part of this effort and can benefit when we have a code that is simpler and fairer.”
Among other items of contention and concern for homeowners and financiers, the proposed act would limit mortgage interest deductions and gradually step down the maximum amount. The current limit is $1.1. million on a principle and second residence, but the reform bill would limit that to $875,000 in 2015, $750,000 in 2016, $625,000 in 2017 and $500,000 in 2018 and beyond.
Camp’s bill would also repeal the real estate tax deduction for state taxes in states with a property tax, and tighten the requirements for the exclusion gains from a principal residence sale, extending the residency requirements. Finally, the bill eliminates in 2015 the moving expenses deduction and repeals green home improvement tax credits.
I used to believe the lie that the mortgage interest tax deduction was a tool to promote home ownership. Now I understand it to be a subsidy from fly over country to coastal states. It’s good to see congressmen representing these fly over districts, doing something about this welfare law. I’m sure the NAR won’t like this.
As I read/understood this proposal, the MID change would only apply to new mortgages acquired after the potential effective date (refis applicable if new money added).
The mid is a subsidy for anyone selling mortgage debt and derivatives of mortgage debt.
“…Rep. Dave Camp, R-Mich., unveiled his Tax Reform Act of 2014…”
Based on what I read, certainly seems a step in the right direction.
Would of like to have seen MID step down to $0 past 2018 instead of $500K. For once in my life, I would like to walk into a open house and not have the realtor start pounding out “remember all the tax benefits”
Betcha the NAR, CAR and even the big banks will fight to the death on this one.
I think the basic math behind this is sound, but what I question is whether mortgage rates will rise faster than wage inflation. It seems to me the Fed can keep rates low indefinitely using employment and stagnant wages as the excuse. There’s really nothing forcing their hand and if another downturn occurs, the consensus will be that the Fed should intervene and lower rates.
Good point. The lack of wage growth will likely temper the increase in mortgage rates. The one offset could be the rapid rate of amortization on low interest rate loans. Since these loans pay off so quickly, as long as affordability doesn’t crumble faster than loans amortize, owners could still sell, albeit with less equity in their pocket.
its one thing if you’re Japan 20 years ago, in a falling interest rate environment
saying ‘indefinitely’ in 2014 is betting on a best case scenario
edit: a centrally planned best case scenario
these people are but morons with a printing press.
The Fed taper means they will have less ability to hold rates down. Rates will rise as they continue their exit from QE. If Yellen is the dove many think she is, how bad will it get, and how far into a stall will we go, before the Fed starts a new flavor of QE with the purpose of driving rates down?
The economy is not as strong, nor likely to grow as much, as the government statisticians have argued. Tax revenues may have bumped due to increased taxes on inflated stock sales, but that is likely to end soon as well. Meanwhile we run larger deficits. Who will finance at low rates if not the Fed?
My opinion is that the Fed will return with more QE to force rates down, but we may have to experience a hiccup in the economy first.
Sales will fall a some as the cost of ownership rises. Then investors will buy up the homes that go up for sale and we will become a nation of renters. You will soon see 3 families moving into a 3 bedroom house just so they can afford the payment.
Sounds like Santa Ana.
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