Dec132016

Rising mortgage rates will price out marginal buyers in 2017

If mortgage rates keep rising, home sales will be lower in 2017 than in 2016, prompting talk of another housing recession.

distressed_borrowersRemember all those stories assuring us that higher mortgage rates wouldn’t cause any problems with housing? Well, today’s featured article is the story where they debunk years of wishful thinking and expose the masses to basic math. It was a long time coming, but I’m glad the financial media is finally breaking the bad news.

This isn’t rocket science. It doesn’t take a supercomputer or a math savant to calculate how much rising mortgage rates will hurt the market. And it doesn’t take a genius or a housing market guru to decipher how this will impact housing.

For every 1% mortgage interest rates rise, it raises the cost of ownership by 11%.

As ownership costs rise faster than incomes, marginal buyers get priced out of the housing market and sales suffer.

It’s really that simple — and it’s always been that simple, despite pundits’ obfuscation of the obvious.

The first batch of nonsense usually revolves around the poor correlation between mortgage rates and home prices in the past. In 2013, I wrote that Future housing markets will be very interest rate sensitive.

Economists who focus on larger trends, the so-called macro-economists, pointed out that housing markets in the past haven’t been very sensitive to fluctuations in interest rates. For example, during the 1970s, interest rates rose significantly, which should have caused house prices to drop, but instead California inflated a housing bubble. During the crash from the bubble in the 1990s, interest rates declined, and so did prices. The same lack of correlation showed during the housing bubble and bust.federal-reserve-econimists

With these significant periods when mortgage interest rates didn’t impact house prices the way the math would suggest, why would the housing market be more sensitive going forward? The the new residential mortgage rules take away the mechanisms lenders used to inflate prior bubbles.

In 2015 I noted that the Federal reserve underestimates the sensitivity of housing to mortgage rates. Despite the groundbreaking change to real estate markets caused by Dodd-Frank, most housing market analysts and real estate economists failed to recognize the impact of these changes on the market, and they continue forecasting based on previous history and their previous understanding of how housing markets used to work.

Later in 2015 I offered clear proof that rising interest rates kill home sales. After the passage of Dodd-Frank, if interest rates went up, sales went down, and visa versa.

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Apparently, analysts are prepared to let the public in on this salient fact.

Rising Mortgage Rates Could Threaten Housing Demand in 2017

Sustained increases could lead to ‘rate lock,’ leaving some homeowners reluctant to trade up or down

[Actually, rate lock is not a real phenomenon, and it will not be the cause of the problem. Higher borrowing costs will be the real problem.]

By LAURA KUSISTO, Dec. 11, 2016reluctant-seller

Rising interest rates pose a dilemma for people who love their mortgage more than they hate their house.

A sustained period of rising rates could freeze homeowners with rock-bottom mortgages who otherwise might want to trade up for bigger or better properties.

Such situations, which economists call “rate lock,” could weigh on housing demand in 2017, economists said.

This is a bogus concept. Locked-in low mortgage rates will not dissuade today’s homebuyers from selling later. Buyers will still be able to participate because they will have more equity from the sale of their current home.

Assuming house price appreciation is tepid, the move-up price will not be much higher than current pricing. So where will the equity come from to make a move-up?

Amortization.

Low-interest rate loans amortize much more quickly than high-interest rate loans. Even if the move-up buyer only sells for enough to cover the transaction costs, they will still have a significant amount of equity to put 20% or more down on a move-up sale, and since they will stretch their amortization from the 25 to 23 years remaining on their old mortgage, between the amortization equity and the extended amortization schedule, they will be able to complete the move-up trade.

A seven-year run of historically low mortgage rates has encouraged home buying, helping increase prices sharply after the housing crash. The S&P CoreLogic Case-Shiller U.S. National Home Price Index reached a record in September.

But mortgage rates have jumped more than half a percentage point since the election, and economists are bracing for higher rates in 2017.

na-cm658_ratelo_16u_20161209171805

The average rate for a 30-year fixed-rate mortgage rose to 4.13% last Thursday, according to mortgage company Freddie Mac, up from 3.54% before the election. That was the highest level since October 2014.

The latest bump boosts the monthly cost of owning the typical U.S. home by more than $70 a month, or about $26,000 over the life of a 30-year fixed-rate mortgage, according to Black Knight Financial Services, a mortgage and real estate technology and data provider.

I suspect it’s already having an impact at the margin. Another half a percent and the impact will be substantial,” said Lou Barnes, a capital markets analyst at Boulder-based Premier Mortgage Group.

It was substantial in 2013 when the taper tantrum caused a 1% rise in mortgage rates in a 6 week period. If not for the persistent downward drift of mortgage rates since then, both sales and home price appreciation would not have been as good as it was over the last three and one half years.affordability_ceiling

Homeowners in pricey coastal markets, where affordability is already strained, could feel the pinch sooner. In California, where the median-priced home is closer to $500,000, homeowners already are looking at paying about $170 more a month based on the recent rate rise. …

Many economists expect mortgage rates to continue rising gradually from here, though such predictions have been wrong before.

Rates have risen because the economy is strengthening and investors are betting that tax cuts and increased government spending on infrastructure will spur more growth. Higher wage growth could offset the effect of higher mortgage rates.

Remember, it takes 11% higher wages to offset a 1% rise in mortgage rates. Since wages rarely rise more than 3% per year, mortgage rates must rise very gently in order for rising wages to make a dent in them — and that’s just to break even. Home price appreciation is off the table in a rising rate environment.

Recent history suggests the impact of rising rates can be swift and substantial. In 2013 mortgage rates surged to 4.5% from 3.6% as investors anticipated the Federal Reserve would pull back from its bond-buying program. The pace of sales of previously owned homes declined 8% from July to December of that year, according to the National Association of Realtors.

The rate of home-price increases around that time was cut essentially in half, to 5% from 9%, according to Black Knight.

“If 2013 is any guide, we could expect to see a slowdown in [price] appreciation,” said Ben Graboske, vice president of Black Knight’s data and analytics division. “We still think house prices will grow, just more meekly.

Affordability cushion

The good news is that we have some cushion before rising mortgage rates really start to hurt sales or put pressure on prices. Even in Irvine, the market is still undervalued by over 12%. Mortgage rates could rise a full percentage point before this market would be considered at fair value.

2016-12-Resale.xlsx

While any rise in mortgage rates will price out marginal buyers, mortgage rates would have to rise above 4.75% before they start having a noticable impact on sales.

2016-12-Resale.xlsx

Rent and income growth will also help out. While it’s unlikely that wage growth will keep up with eroding affordability, since we still have a 12% cushion of affordability to work with, the medium-term impact of rising mortgage rates won’t be dire. However, if mortgage rates rise about 5.5% and keep going, then sales will plummet and prices won’t be far behind.