Oct272009

Ownership cost: interest rates and down payment requirements

Four Major Variables that Determine Market Price

Yesterday, we discussed the four variables that determine the purchase price of a property:too_little

  1. borrower income,
  2. allowable debt-to-income ratios,
  3. interest rates, and
  4. down payment requirements.

Today we are looking at interest rates and down payment requirements.

Interest Rates

Interest rates go up, and interest rates go down. Interest rates are the yield on debt instruments. If investors lose their appetite for mortgage debt, prices of mortgage-backed securities goes down, payment yields go up, and mortgage interest rates go up with them. This concept is important to understand because right now, the Federal Reserve is the only buyer of agency paper at price levels yielding 4%.

Private investors are demanding higher returns due to the obvious risk of loss in a declining market. The Federal Reserve feels it needs to step in to stabilize crashing markets by preventing an over-correction in risk premiums to make the free-fall worse. In crashing markets, 8% mortgage interest rates probably do not warrant the risk of default loss.

The FED will retain this defensive market safety net until risk premiums and market mortgage interest rates get close enough to their support price that they can begin to unwind the program. It isn’t likely that private investors will return to buy mortgage debt at 4% yields any time soon, so the FED will have to be cautious in how it unwinds its supports.

This government intervention underscores the difficulty of forecasting interest rates and how fluctuations will impact the housing market. Think back to early 2008 when there when people still denied the housing bubble. Nobody imagined the Federal Government would assume ownership of the GSEs (at the time they were private companies), and that the Federal Reserve would be buying GSE paper at over-market prices. These unprecedented events would suggest a market cataclysm — the fodder of conspiracy theory nutters. Yet, here we are.

Interest Rates have a major impact on how much someone can borrow.

The big fear rational people have is that mortgage interest rates will rise back to historic norms of 8% or go even higher. If this happens, the housing market can easily drop another 30%. This may be the fate of Irvine. As I look around at other nearby markets, they have already fallen to the point where nice properties that would be above rental parity here are trading for cashflow investor levels. A 30% drop in affordability in beaten down markets will not necessarily push prices lower because they have already overshot fundamentals. Irvine is not trading below rental parity or below historic norms; it has a long way to fall.

The chart above illustrates an important financing point and a legitimate reason not to buy a house.

it will be interesting to track the future and see where mortgage interest rates peak during the next cycle. If we really do get high inflation, it may move much higher than 8%. It is realistic to believe mortgage interest rates will hit 7.5% at the peak of the next cycle in 2018. Are they staying at 4% forever?

The table shows how rising interest rates will effect median price in Irvine at rental parity. What happens if mortgage interest rates are allowed to find a natural market? How do we know where the natural market is?

Currently, prices yielding 5% do not catch the long tail of market demand. The Federal Reserve is buying 100% of the agency paper. If prices were at market clearing prices, the Federal Reserve would be buying 0% of the agency paper market. The long tail of demand may be very near the natural market clearing price, or it may be very far away.

I am inclined to believe it at least as far away as the 6.76% peak of the last cycle in July of 2006. At the peak of that cycle, financial markets were delusional about mortgage risk at the peak of the housing bubble. Risk premiums are certain to be higher now.

If interest rates merely reach the previous peak, it removes 15.1% of the borrowing price support. If interest rates move back to their 37-year mean of 8%, 26.8% of the borrowing price support is removed from the market.

Do you realize that prior to 2002, mortgage interest rates had only been under 7% one time in the previous thirty years? It hit 6.9% in 1998. During our last interest rate cycle during the wild credit expansion of The Great Housing Bubble, the peak did not reach the previous 30-year low.

I think it is very reasonable to assume mortgage interest rates will move higher, perhaps much higher.

Are you comfortable buying with that much of the price support is air from the Federal Reserve?

Down payment Requirements

Down payment requirements have traditionally been very high. During the 1920s, interest-only loans with 50% down payments were the norm. Very few people owned their houses. By the 1950s, conventionally amortized loans with a 30-year term and 20% down payments became the norm, and house prices rose significantly from the bottom of the Great Depression to the 1950s due to the increased use of leverage in real estate.

That is the end of the road for financial innovation. All attempts to tinker with the stability of conventional financing have failed because they are all Ponzi Schemes. People must have a reasonable expectation of paying off a loan in their lifetime. Multi-generational debt is frowned upon here in the United States, so any term beyond 30 years really doesn’t make sense. If you feel like you will never pay it off, you will not try, and you fall into Ponzi thinking and borrow in terms of maximum debt service. It is crazy.

By 2005, Option ARMs and 100% financing left us with 0% down payments as the cycle reaches its ultimate limitation — they are giving it away. Not surprisingly, prices skyrocketed; unfortunately, the terms of the Option ARM were not stable and the Ponzi Scheme blew up. We are back to the 1950s in the world of mortgage finance — that is a good thing.

The 30-year fixed-rate fully-amortizing loan is the only stable loan product, and a significant down payment is required to keep down speculation. As down payments get smaller, the incentives to speculate with lender money get larger. With no-money-down the incentive to speculate hits infinity. One-hundred percent financing with no qualification is a free-for-all no-limit housing market casino.

Savers gain advantage bidding on real estate.

My calculations of value in the table at the top of the post assumes the down payment added to the loan to obtain value is 20%. Irvine buyers are unique in that they put in very large down payments. Most buyers don’t have 20% down. Most buyers don’t have the current FHA standard 3.5% down either, or we wouldn’t have tried 0% down to begin with.

When it is an FHA buyer, they generally only put the minimum 3.5% down. The loan plus the down payment is about 16.5% lower for an FHA buyer than it is for a conventional borrower putting 20% down, assuming both are qualified using the same income and same DTI.

In the real world, the conventional borrower is also utilizing a higher DTI ratio. Instead of being limited to the FHA 31% front end DTI, conventional borrowers are often allowed to go into dangerous waters with 32% to 38% DTI levels. This additional money put toward debt service makes for larger loans.

The borrower with enough cash to put 20% down has a significant bidding advantage over the FHA buyer. The lower down payment amount and the smaller loan balance make FHA less desirable than conventional financing for borrowers looking to bid up prices. FHA financing can be looked at as training wheels for mortgage borrowers.

After some period of time in a normally appreciating market (if there is such a thing), the combination of loan amortization and home price appreciation results in home equity exceeding 20% of the resale value of the property. When there is enough home equity that a more expensive house than your own house could be purchased with 20% down using your equity as the down payment, you cross a threshold; you have access to the higher DTIs, and you can borrow more money to take the next step up the property ladder — if you are willing to give up some disposable income to have the house.

In the end, it is not the highly leveraged that gain the upper hand in real estate, it is the savers. The real estate market will always boil down to loan plus down payment. The more money you have saved, the greater your down payment and the more you can bid to compete with others at your income level. The saver always comes out ahead.