The bearish arguments for real estate boil down to two points: (1) overhead supply will overwhelm demand, and (2) rising interest rates will lower loan balances. These are two very different arguments. The supply argument is is based on the total number of homes demanded through household formation. The interest rate argument is based on the total amount those new households can borrow.
I believe the first argument is compelling. There are too many houses to be absorbed by current demand. We know lenders are trying to match the rate they obtain foreclosures to the rate they sell them. In the process they have amassed a huge shadow inventory they are now planning to sell to private equity groups to hold as rentals. There is little doubt the overhead supply is much larger than the demand in the short and medium term. This may or may not push prices lower, but it almost certainly will prevent any substantive appreciation.
Today I want to focus on the second argument. Will rising interest rates cause house prices to crash? I want to start by saying there is no question that higher interest rates make for lower loan balances. If this were not true, the federal reserve wouldn’t be buying mortgage-backed securities to lower interest rates. The math is inescapable.
| Interest Rate Table | |||
| $95,748 | Irvine Median Income | ||
| $7,979 | Irvine Monthly Median Income | ||
| 31.0% | Debt-To-Income Ratio | ||
| $2,473.49 | Monthly Payment | ||
| Interest Rate | Loan Amount | Value | Value Change |
| 9.00% | $307,410 | $384,262 | -41% |
| 8.50% | $321,686 | $402,108 | -38% |
| 8.00% | $337,096 | $421,370 | -35% |
| 7.50% | $353,753 | $442,191 | -32% |
| 7.00% | $371,784 | $464,730 | -28% |
| 6.50% | $391,333 | $489,166 | -24% |
| 6.00% | $412,557 | $515,697 | -20% |
| 5.50% | $435,635 | $544,544 | -16% |
| 5.00% | $460,766 | $575,957 | -11% |
| 4.50% | $488,171 | $610,214 | -6% |
| 4.00% | $518,100 | $647,625 | 0% |
At today’s 4% interest rates, borrowers can comfortably leverage over five times their yearly income. The 40-year average for interest rates is 9%. At that interest rate, a borrower can 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-two years.
As is evident in the very long term chart of interest rates above, the interest rate cycle is very long. Alan Greenspan presided over a twenty-five year period of declining interest rates. Much of the increase in value of real estate is attributable to decreasing borrowing costs over that time. Inflation was relatively tame, so Greenspan always had the luxury of lowering interest rates to increase economic activity. Those days are gone.
When the interest rate cycle reaches bottom, the value of the currency declines, and cost-push inflation becomes an issue. As Americans want to buy products from overseas, it takes more and more dollars to do it because the currency is declining in value. Unless we get a commensurate increase in our exports (or cheap money from China), our standard of living will decline. 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. When Bernanke finally does start raising interest rates, we will be embarking on the next multi-decade rising cycle where inflation is a constant problem.
If interest rates go on a sustained rise, financing home purchases will become more expensive. That is the math. The real question then is whether or not these rising interest rates are compensated for 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 will fall again. Given the choice between inflation and falling house prices, which do you think Bernanke or a future central banker will chose? After the all-out effort they have made to prop up house prices over the last several years, I suspect they will chose inflation, a devalued currency, and steady house prices over a strong currency and falling house prices.
The housing recovery that wasn’t
By Nin-Hai Tseng, writer-reporter January 30, 2012: 5:00 AM ET 
The evidence for a recovery is compelling, but optimists should actually be watching rising interest rates.
FORTUNE — Over the past few months, a spate of good news about the U.S. housing market has led some to think a recovery is finally on the horizon.
The evidence is compelling. It now costs almost as much to rent as buy. Since the housing bubble burst in 2006, home prices have fallen by 33% nationwide — more than they did during the Great Depression. Waves of foreclosures and tighter lending standards have helped drive a surge in rentals. And during the third quarter, the median monthly mortgage payment totaled $698 compared to the median monthly asking rent of $700, according to Capital Economics, citing data from the National Association of Realtors and the Census Bureau. What’s more, the cost of borrowing has fallen to record lows, with interest rates for 30-year fixed rate mortgages hovering around 4%.
Even here in Orange County it is finally less expensive to own than to rent thanks mostly to four percent interest rates but falling house prices have helped too.
Builders are even building again. (Albeit, at a very modest pace and driven largely by construction of multi-family homes.) As a January report by CoreLogic shows, both single-family starts and permits rose at an annualized pace of 15% over the six months ending November 2011. The California-based mortgage data provider also notes that existing home sales nationwide have been trending up, rising 12% higher in November 2011 compared with January 2011. “While we cannot say with a high degree of certainty that 2012 has in store for us, indications based on the latter part of 2011 are that both the broad economy and the housing market are moving toward positive growth in 2012,” CoreLogic wrote in a research note.
That optimism is well-deserved, right? Not exactly.
Since the housing market imploded, analysts have predicted year after year that prices might at long last bottom out.
Will it finally happen this year? Perhaps next? Bottoming out necessarily precedes turning the corner — and until that happens optimists should be cautious. Economists widely cite the short-term obstacles weighing down prices. These factors range from high unemployment and household debt to the so-called “shadow inventory,” or all the properties that have yet to come into the market because of pending foreclosures or skittish homeowners delaying sales until prices improve.
These threats are very real. But there’s a bigger threat — and drag on any future recovery — that doesn’t get nearly the attention it deserves: rising interest rates.
Admittedly, rates probably won’t increase any time soon. In a sign that the economy is recovering slower than expected, the Federal Reserve announced last week that it would keep its record-low rate for another three years. The central bank has already kept its key rate at nearly zero for three years.
Does is seem plausible after the federal reserve’s recent behavior that they may chose to keep interest rates down to save housing no matter the cost? They have never openly committed to leaving interest rates low before.
And last summer, officials launched “operation twist,” whereby the central bank bought $400 billion in long-term bonds in hopes to give the economy a boost and, more specifically, lower the cost of taking out home mortgages.
Is there anything the federal reserve will not do to save housing?
Problem is, interest rates can’t stay low forever. Eventually they’ll have to rise, which could very well drive home prices down since the cost of taking out a mortgage becomes more expensive. Even if rates rise slowly over several years, prices could either fall much further or, at best, stagnate. This is partly why the Fed has been so obsessed with keeping rates down. “The market will look like a frog in boiling water once rates rise,” says Lance Roberts, CEO of Streettalk Advisors, a Houston, Texas-based investment advisory company. Roberts, who also contributes to Advisor Perspectives, which publishes newsletters and online articles focused on investment strategies, laid out his case in a recent post.
The post linked to above is well worth the time to read.
At some point, interest rates will start rising back toward the long-term median of 8.9% from the current 4%.
See table above for the impact of this increase.
Depending when and how quickly, the jump would make homes much less affordable for the average American family. Roberts notes that, back in 1968, U.S. households on average spent 7% of their real disposable income on their mortgage payment with a down payment typically at 20%. Assuming the same down payment, that share has more than doubled to 15% today or likely higher since many mortgages approved over the last decade required little or no money down. “With real disposable incomes stagnant as inflation pressures rise, that 15% of the budget is becoming much harder to sustain,” he says.
Say a family earning $55,000 a year (the U.S. median household income) wants to buy a home. They decide they can afford roughly a $600 a month mortgage payment after taxes and other expenses. At a 4% interest rate they can afford a $125,000 home. However, at a higher rate of 5%, they can’t afford as much and are looking at a $111,000 home. If rates rise higher to 6%, they’re looking at a $100,000 home. And so on.
So while the housing market may eventually overcome the immediate bumps of foreclosures, high unemployment and the like, real optimists should be looking at the direction of interest rates before they get their hopes up.
Interest rates and wage growth are the two most important variables impacting future house prices. Will they both go up? If so, it may be a wash. If wages go up and interest rates do not, house prices will rebound strongly. I don’t consider that scenario very likely given how low interest rates are today and how high unemployment is. If interest rates go up and wages do not — a probably outcome given the circumstances — then house prices will be weak for a very long time.
For more news, market analysis and property profiles, please see the North OC Housing News.
Proprietary OC Housing News home purchase analysis 
2107 LEMON HEIGHTS Dr North Tustin, CA 92705
$1,599,000 …….. Asking Price
$1,690,000 ………. Purchase Price
1/15/2004 ………. Purchase Date
($91,000) ………. Gross Gain (Loss)
($135,200) ………… Commissions and Costs at 8%
============================================
($226,200) ………. Net Gain (Loss)
============================================
-5.4% ………. Gross Percent Change
-13.4% ………. Net Percent Change
-0.7% ………… Annual Appreciation
Cost of Home Ownership
——————————————————————————
$1,599,000 …….. Asking Price
$319,800 ………… 20% Down Conventional
3.92% …………. Mortgage Interest Rate
30 ……………… Number of Years
$1,279,200 …….. Mortgage
$303,244 ………. Income Requirement
$6,048 ………… Monthly Mortgage Payment
$1,386 ………… Property Tax at 1.04%
$0 ………… Mello Roos & Special Taxes
$400 ………… Homeowners Insurance at 0.3%
$0 ………… Private Mortgage Insurance
$0 ………… Homeowners Association Fees
============================================
$7,834 ………. Monthly Cash Outlays
($1,303) ………. Tax Savings
($1,870) ………. Equity Hidden in Payment
$430 ………….. Lost Income to Down Payment
$420 ………….. Maintenance and Replacement Reserves
============================================
$5,511 ………. Monthly Cost of Ownership
Cash Acquisition Demands
——————————————————————————
$17,490 ………… Furnishing and Move In at 1% + $1,500
$17,490 ………… Closing Costs at 1% + $1,500
$12,792 ………… Interest Points
$319,800 ………… Down Payment
============================================
$367,572 ………. Total Cash Costs
$84,400 ………. Emergency Cash Reserves
============================================
$451,972 ………. Total Savings Needed
——————————————————————————————————————————————-
This property is available for sale via the MLS.
Please contact Shevy Akason, #01836707
949.769.1599……
sales@ochousingnews.com…..
We're sorry, but we couldn't find MLS # P800474 in our database. This property may be a new listing or possibly taken off the market. Please check back again.
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41 Responses to “Will rising interest rates cause house prices to crash?”
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Just amazing how your purchasing power declines from 4 to 8 percent
The fed will defend ultra low rates until it can’t, which means at a certain point, the incremental cost of debt capital is going to destroy $billions in equity values going forward.
Declining values = destiny; ie.,
FHA: Reaching critical mass
It’s probable that half of all the low-FICO score and high-loan-to-value loans that were backed by the Federal Housing Administration during the peak of the housing bubble will default.
http://www.housingwire.com/article/fha-reaching-critical-mass
FHA has been the dumping ground ever since the market imploded. While all the banks were making windfall profits hand over fist easy money originating Government-backed subprime loans. Absolutely shameful how a program originally implemented to help low income buyers is being used to flip houses on the order of 700K in some areas. It makes 2003 look like the good old days of responsible lending.
Home prices decline for third consecutive month
By Alejandro Lazo
January 31, 2012, 6:54 a.m.
Home prices in the nation’s biggest cities fell for the third consecutive month in November, a sign the housing market ended 2011 in a weakened state.
The closely followed Standard & Poor’s/Case-Shiller index showed price declines in 19 of the 20 cities it tracks in November – the second month in a row that nearly every city in the index was in negative territory. The index fell 1.3% month-over-month and was down 3.7% from November 2010.
Home prices often fall during the winter months as more purchases are done in the spring and summer months. But the three consecutive downward drops mean prices are likely to continue to keep falling in 2012.
“Despite continued low interest rates and better real GDP growth in the fourth quarter, home prices continue to fall,” David M. Blitzer, chairman of the Index Committee at S&P Indices, said in a statement.
Atlanta continued to show the most pain, posting a new index low. That city was down 2.5% over the month, after dropping 5% in October, 5.9% in September and 2.4% in August. Las Vegas, Seattle and Tampa, Fla., all reached new lows in November.
In Los Angeles, prices were down 1% in November after falling 1.5% the month before. Year over year, L.A. prices are down 5.4.%.
Given the continued malaise in the housing bust, the Obama administration has taken new measures to try and right the housing market as it enters its fifth year of decline. Last week it announced the expansion of its signature foreclosure relief program, a new refinancing plan and a new investigative unit that will further probe the mortgage-related abuses that caused the collapse in housing.
This gradual descent is all about shifting a tremendous lead weight from the banks to the consumer. I see this as a “surrendered decade” where the Fed will give up 10 (or more?) years in order to have an orderly descent with the housing market. However, once the banks have reduced their exposure, will the Fed protect the consumers? My guess is no. My bet is the Fed is trading billions in loan losses for the billions in equity value destruction that el Oracle refers to. The Fed sees a final chapter of the book being each taxpayer paid several thousand dollars and all house buyers agreed to shoulder a few extra thousand dollars of burden through equity loss. They hope the pain isn’t as noticeable since it will be over several years rather than the immediate realized loss the banks would have had.
Think of it as the Federal version of the California lottery. If we really wanted to help the schools in CA, there are many more efficient ways of doing it than buying a lottery ticket. However, we punish people who suck at math by having them shoulder the extra burden even if that means only a few pennies on the dollar go to our main goal. The 99% that stink at math are being conned by the Federal Government Lottery. Go ahead and buy a house. You may win but we all know that you won’t. But you are shouldering your extra “tax” burden so I don’t have to.
Very good analysis of the situation. The federal reserve will opt for the slow bleed if it can. I doubt they would let inflation get too far out of control because it will hurt their member banks, but they can’t let house prices fall too much either because that hurts the banks. The middle ground is to slowly allow interest rates to rise while keeping house prices stable. Buyers and today’s owners feel the pain, and so does the taxpayer. The pain to the banks is minimized.
Don’t forget the savers taking it on the chin. Money market savings account is now paying 0.65% after seemingly having leveled off at 1% for about a year. I don’t even bother checking the balance anymore – they might as well drop it all the way to zero. Why pay any interest at all? all the banks move in lockstep with one-another at each lowering of the bar so that you have no better option at any place else.
Exactly. We are being farmed, probably for SPAM. As the article notes, “…lenders …. have amassed a huge shadow inventory they are now planning to sell to private equity groups to hold as rentals.”
Instead of allowing private individuals to buy a house at market rates, then possibly saving to buy another house to rent out, the plan is to offload scores of cheap properties bundled together to private equity collectives which will serve as landlords. This is as paternalistic (“The individual is too irresponsible to own a house”) as the former campaign (“EVERYBODY gets to own a house!”). Is this some kind of Paperwork Reduction Act, consolidating ownership to corporations? Check out the membership roster of those equity owners: that’s right, the same people who caused the mess.
In 1940 the median home price in California was $3,527 and in 1980 it was $84,500.
http://www.census.gov/hhes/www/housing/census/historic/values.html
Despite rates going from 2% to 14%, home prices managed to eke out a 2,300% gain over that time. History shows inflation’s effect on home prices overcomes its effect on interest rates.
If prices are being pushed up by rapid inflation, then people will borrow money at a higher rate because appreciation will make it worthwhile. The old adage to “buy as much as you can afford” will become popular again, and even if DTI ratios are stretched to the limit, inflation will soon cure that with cost-of-living raises and overnight equity gains thanks to a rapidly depreciating dollar.
Banks will be the real losers over the next 30 years, because as you said, the Federal Reserve is always one step behind.
There you go… dreaming of the good ‘ol days again. C’est la vie.
Reminder: Over half of the US households are not bankable.
Next!
At the Low and mid range end, demand is only low because it is very hard to get a loan without 20% down right now (most likely that will change).
Really to require 20% down makes no sense now, it did in 2003-2006 but not now.
What you are saying really only applies to investors.
FHA is available to owner-occupant buyers with a minimum 580 FICO score, 3.5% down payment, DTI’s up to 48%, and no reserves. Fannie Mae also offers a HomePath mortgage with 3% down payment and no mortgage insurance requirement if you buy one of their REO’s.
Obama is now trying to expand FHA refi’s to underwater borrowers that don’t have Fannie or Freddie loans.
Is FHA still allowing FICO’s down to 500, but you would need 10% down?
I believe so but most banks still wouldn’t underwrite that, especially now with FHA’s new focus on making banks buyback loans that default.
And I fully support the expansion of FHA refis on qualified underwater homeowners!
Geez, how do you get a FICO of 500?
Tax payers will be riding to rescue FHA in the near future. The smoke is in the air.
DTI up to 48%? I seen 38%, but 48% wow. That’s a little too high.
That’s about the highest I’ve heard of. It requires some compensating factors though; Suppose you have a lot of assets, but low income on paper. It wouldn’t be viable for the average Joe. A 36-38% front end DTI is more the norm, but still crazy if you think about that being a percentage of gross income.
I got one of those high DTI loans. But, lots of compensating factors like enough assets to buy the home cash and most of the D being payments on 15 yr rental loans. And with that the loan app was over 200 pages of requested docs. Managed to get the loan closed a few days before the short sale expired. Very stressful…
Not for joe six pac.
Try talking to a few first time buyers, esp in a place like Vegas, very few get through the qualifying process., you would think it was not so but it is.
“Really to require 20% down makes no sense now, it did in 2003-2006 but not now.”
It made sense then, and it makes sense now. The adjustment is painful, so people resist it, but most loans should be 20% down, and house prices should be much lower to accommodate.
Even with today’s crazy-low interest rates, if I put 20% down on a $500k house I’d still be paying more per month than I currently do to rent. And the fact is, there’s no such thing as a $500k house anywhere close to where I live. The cheapest “decent” house that I know of near-by recently sold for $650k, and that was a crappy stucco box that I’d never even consider buying. No matter where interest rates go, home prices need to go down a LOT for people like me to jump in to the market. My wife and I make over $200k/year and have hefty savings. But we’re not insane – this market is…
Ya I make over $100,000 a year too. But since my wife stays home, it’s housing poor.
You may not be insane, but most others are, as evidenced by the still-high prices you mention despite the turmoil of the last five years.
You’re defnitely not insane and neither am I. I make ~$450K/year and rent a 900 sq apartment in Orange County. Been trying to keep the wife off the buying bandwagon for as long as I can. Irvine Renter always talks about how buying a house is at rental parity, but when you factor in declining prices of at least 3-5%/year for the foreseeable future and that my financial advisor can get me 5-7% on my hard earned savings, why would I ever buy?? And if you do buy and ever need to sell, you are HOSED. Severely hosed. The sheeple haven’t changed their psychology enough against housing…..yet, but when that does happen then it will be time to buy. I may rent a house for a while to watch how this blood bath unfolds, but buy then we may be considering expatriating all together.
*by*
My heart is with you all: We’re living in 1000sf on $28k/yr. We have $300k in reserve thanks to an inheritance currently being piddled away with inflation and mismanagement. I wouldn’t live in anything I could buy for $300k and neither would I have the funds to fix it up. I know, boohoo, but if you’re struggling with $450k, just think of the life you could live on 15% of that.
PO’d, where does your advisor get you 5-7% on savings?
Who is your financial advisor? We are too scared of this @#$@ market to buy. I need a 5-7% return!!!
You can bet that in an inflationary situation where there is no significant demand for employees, salaries will not move up with inflation. Witness increased food and fuel prices over the last few years with no increase in salaries.
” Given the choice between inflation and falling house prices, which do you think Bernanke or a future central banker will chose? After the all-out effort they have made to prop up house prices over the last several years, I suspect they will chose inflation, a devalued currency, and steady house prices over a strong currency and falling house prices”
You’re correct, right until the dollar officially loses its reserve currency status then collapses. Then we get to see what happens in a real market economy and that will include honest (and much higher) interest rates. The dollar is well on its way down this path and it makes housing more difficult to hide out in.
“You can bet that in an inflationary situation where there is no significant demand for employees, salaries will not move up with inflation. Witness increased food and fuel prices over the last few years with no increase in salaries.”
The experience over the last few years is why I don’t see wage inflation keeping up. Unemployment is far too high for workers to start demanding raises. They may feel the pinch of rising costs, but the average worker is in no position to bargain with their employer for more money.
Most people believe heavy devaluation is coming. But, the $ has already been heavily devalued over time–decades. As a result, sovereigns have begun to dump USD/subvert the petro-dollar system, which puts the reserve currency status at risk.
At this point, follow the bombs. Their purpose is to preserve the reserve system/value of the money. (ie., see Iraq; Libya)
Q: Why do you think the fed and its proxies continue to attempt to suppress gold prices?
Silly ORACLE… The Fed would be raising rates if they wanted to supress gold prices.
c’mon man….. free your mind.
step out of the box, for once
Wages never rise as fast as prices. That’s why inflation is painful. It’s certainly true that *some people* will do well if inflation raises interest rates and the prices of houses — those who can carefully ride the wave — but that’s like saying some people can profit from a stock market boom, and others from a stock market bust. Lucky people will always be, well, lucky.
But most people won’t be lucky, that being inherent in the definition of luck, and most people will find their savings — including what they’ve saved in equity in their houses — eroded, that being the essential definition of as well as universal historical experience of inflation.
People have forgotten how destructive inflation is. As you noted, there will be winners and losers, but there will be more losers. The people who will get really hurt are those whose savings are in currency sitting in bank accounts. Seniors savings will get wiped out. They better hope the government doesn’t find some imaginative way to mess with their cost of living adjustments. It’s the only hope many of them have.
So, …
What will do well in this situation?
Hard assets and foreign bonds.
[...] Will rising interest rates cause house prices to crash? - OC Housing News [...]
Nearly $1.9 invested in 2003!
The “r”ealtors are still trying to party like it is 2003. I love it.
It’s good to see you, David. Thanks for stopping by.