Homebuyers unprepared for reality of rising interest rates

I strive to educate this blog’s many readers and dispel the fallacies surrounding residential real estate. Sometimes, the public impresses me with their wisdom; For example, adjustable-rate mortgage use is very low despite rising rates. However, sometimes I am shocked at how many people become confused by simple concepts. For example, Redfin recently took a poll and showed that 83% of homebuyers thought a 5% interest rate was normal. They were rightfully disturbed by the financial illiteracy of buyers.

Mortgage interest rates only recently fell below 5%.

The only time in US history interest rates were as low as the last two years was in the aftermath of the Great Depression and World War II.

(Chart below shows federal funds rate. Mortgage rates are at least 1.5% higher)

Five percent interest rates are certainly not normal.

83% of Homebuyers Think a Mortgage Rate Below 5% is Normal

by Ellen Haberle | December 9, 2013

… Redfin’s … asked buyers what they considered “normal” for a 30-year fixed mortgage rate.The results gave us serious pause. A combined 83 percent considered a “normal” rate for a 30-year fixed rate mortgage loan to fall under 5 percent.

Normal rates

Under 5 percent? While rates hovered around 4.3 percent in November, they have averaged 6.7 percent since 1990. Rates never once fell below 5 percent until March 2009.

Buyers may not have understood the question. If you ask, “What is a normal mortgage rate today?” you would get a different answer than if you asked, “What is a normal mortgage rate over the last 30 years?” Redfin was looking for the answer to the latter question, but many buyers may have supplied the answer to the former one.

Even more surprising, both seasoned and first-time buyers think a rate below 5 percent is normal; the only difference between the two is that one in three first-timers think a rate below 4 percent is normal, compared to one and four seasoned homebuyers.

Rates by experience

I am amazed that people who paid higher interest rates in the past wouldn’t recognize the current rates as artificially low.

Clearly, the Fed’s easy-money policies since the housing crash have trained buyers to expect mortgage rates that start with threes and fours. Even more worrying, buyers are showing a high degree of intolerance toward mortgage rate fluctuations, another revelation from this month’s survey. More than 40 percent said they would be unable or unwilling to buy a home if rates rose much further.

This explains why sales volumes declined so precipitously when mortgage rates spiked in May. Sales in the Western US are well below last year’s levels.

These data suggest that the housing recovery could be in for an especially bumpy road in 2014 as the Fed weans the country off economic life support. As that happens, it is reasonable to expect rates to exceed 5 percent. …

This summer gave us an idea of what we can expect. Two weeks after mortgage rates spiked about 1 percentage point in June, the number of Redfin customers taking tours and signing offers dropped 14 percent and 12 percent, respectively. At the same time, the number of brand new homes sold across the country plunged 13.4% from June to July.

Clearly, homebuyers are not adjusting to higher rates. The impact of ever-decreasing mortgage rates is similar to auto rebate programs or retail sales programs; After a time, the rebate or the special sale price becomes an expectation, and buyers refuse to pay full retail price. Mortgage interest rates will rise next year, and homebuyers are not prepared for what’s coming.

Bigger issues with mortgage interest rate confusion

This confusion over what’s “normal” for mortgage rates has some unsettling ramifications. I see four main problems:

  • buyers fail to recognize how much past appreciation was manufactured
  • buyers neglect to consider their take-out buyer will not be as highly leveraged
  • buyers underestimate the risk of future downturns
  • buyers distort their expectation of future appreciation

If buyers understood the impact of higher mortgage interest rates, they would make wiser housing decisions.

Past appreciation was manufactured

In the post, Housing market impact of 25 years of falling mortgage interest rates, I documented how falling rates manufactured significant appreciation over the last 25 years, appreciation which would not exist if rates remained flat.

From this data, the impact of 25 years of falling interest rates can be deduced. Look carefully at the cost of ownership line. Notice that in 1989-1991, the monthly cost of ownership was about $2,000 per month at the peak of that housing bubble. In 2012, the cost of ownership was again $2,000 per month. Twenty-four years apart, the cost of ownership on a monthly basis was unchanged, yet house prices were nearly double. Why is that? Because in 1989, mortgage interest rates were north of 10%, and in 2012, they were 3.5%. All the appreciation from 1989 to 2012 was a direct result of declining interest rates. All of it.[dfads params=’groups=165&limit=1′]

So what would have happened if interest rates hadn’t changed?

Let’s go back to the stable period from 1993 to 1999. The average monthly interest rate during that period 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.

By lowering mortgage rates, the federal reserve pulled-forward seven to ten years of appreciation. The market must endure seven to ten years of below average appreciation to balance the equation, or as a statistician would say, we must revert to the mean.

Take-out buyers will not be as highly leveraged

Back in April of 2007 I first wrote about Your Buyer’s Loan Terms. The future resale value depends on how much future buyers borrow. For future house prices to be higher, future buyers must borrow more than today’s buyers. Ordinarily, future buyers would finance larger mortgages because wage inflation would allow them to make larger payments. However, for that system to work, mortgage interest rates must be steady or falling. Rising mortgage interest rates causes the borrowing power of future buyers to decline, and if wage growth isn’t strong enough to keep up, then mortgage balances don’t grow larger, and house prices don’t go up.

Risk of future downturns

Since buyers expect interest rates to remain at or below 5%, they underestimate the risk of future home price declines. Faith in home price appreciation is religion in California, so most homebuyers blithely assume they will sell for a huge profit. But what happens if mortgage interest rates rise faster than wage inflation? Future homebuyers will finance smaller mortgages, and aggregate house prices will be lower than today. Today’s homebuyers are blissfully ignorant to this possibility because they believe 5% mortgage rates are normal.

Distorted expectation of future appreciation

Since buyers believe mortgage rates will remain low, and since house prices recently shot up due to low rates and withheld inventory, kool-aid intoxication is taking over. We aren’t seeing the same foolishness as 2005, but most buyers believe house prices will rise significantly, and this believe is prompting them to buy — the precursors to another bubble.

I detailed what will happen in the post 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.

Buyers obviously fail to grasp this concept. Reversion to the mean for mortgage interest rates is going to weigh on house prices. With lingering unemployment, wage growth will not compensate. Unless the magic appreciation fairy finds a new mechanism to push prices higher, this cycle of bubble reflation will be shorter than previous real estate rallies.

Despite these limitations, I believe prices will rise over the next few years because the percentage of all-cash buyers is near record highs, and they ignore financing constraints. Also, until borrowers escape their bad loans, they will restrict inventory keeping prices artificially high.

After a few years, lenders and underwater borrowers will lose control of the supply. Once organic sellers take over, sales volumes should increase, and sales prices will adjust to levels financed buyers can afford. All-cash investors will exit in a few years, and when they do, they too will need to find a financed buyer. Once interest rates revert to the mean, and once the market adjusts to this new equilibrium, we will finally reach a state of market normalcy. By 2020, we may finally be past the excesses of the housing bubble.

A Competitive Job Market

A reader emailed me the link to a job posting on Linkedin. Take a look at the number of applicants to this job.

If you see this posting, and you see there are already 833 applicants, what motivates you to be number 834? You might as well buy a lottery ticket. You’re probably just as likely to win the $500M+ as you are to get this job.

Real estate news coverage suspended for holidays

Real estate news coverage is suspended from December 21 through December 31. Regular real estate related news posts will resume on January 1, 2014. I apologize for the inconvenience. Since the end of the year is a time of family and reflection, and since it’s not a time many people focus on real estate, I decided to offer something different.

Tony Bliss was a close friend of mine who lost his heroic battle with cancer in late 2012. He wrote about his experience in a series of gripping posts that reveal a beautiful and courageous man. I was deeply moved by these posts — some of which are admittedly difficult to digest. This writing is raw. Real. Be forewarned that if you read his posts, you will never be the same. You will laugh, cry, fear, hope, and stare into the abyss of your own mortality. I am honored to share this great work with you here starting December 21st and concluding December 31st.

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$500,000 haircut

Lenders orchestrated the reduced inventory to cause prices to rise. Their plan is to liquidate their inventory and resolve bad loans at higher market prices so they will lose less money. Despite the rapidly rising prices of the last two years, the bank still stands to lose nearly $500,000 on this property — unless you believe a bidding war will break out and this will sell for $500,000 over the ask.

2800 CATALPA St Newport Beach, CA 92660

$1,078,000 …….. Asking Price
$1,519,399 ………. Purchase Price
7/12/2013 ………. Purchase Date

($441,399) ………. Gross Gain (Loss)
($86,240) ………… Commissions and Costs at 8%
($527,639) ………. Net Gain (Loss)
-29.1% ………. Gross Percent Change
-34.7% ………. Net Percent Change
-66.7% ………… Annual Appreciation

Cost of Home Ownership
$1,078,000 …….. Asking Price
$215,600 ………… 20% Down Conventional
4.98% …………. Mortgage Interest Rate
30 ……………… Number of Years
$862,400 …….. Mortgage
$225,982 ………. Income Requirement

$4,619 ………… Monthly Mortgage Payment
$934 ………… Property Tax at 1.04%
$0 ………… Mello Roos & Special Taxes
$225 ………… Homeowners Insurance at 0.25%
$0 ………… Private Mortgage Insurance
$60 ………… Homeowners Association Fees
$5,838 ………. Monthly Cash Outlays

($1,514) ………. Tax Savings
($1,040) ………. Principal Amortization
$417 ………….. Opportunity Cost of Down Payment
$155 ………….. Maintenance and Replacement Reserves
$3,855 ………. Monthly Cost of Ownership

Cash Acquisition Demands
$12,280 ………… Furnishing and Move-In Costs at 1% + $1,500
$12,280 ………… Closing Costs at 1% + $1,500
$8,624 ………… Interest Points at 1%
$215,600 ………… Down Payment
$248,784 ………. Total Cash Costs
$59,000 ………. Emergency Cash Reserves
$307,784 ………. Total Savings Needed
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Sunrise in San Clemente yesterday morning

I played golf yesterday morning at San Clemente Municipal. On the way there, I was greeted by this sunrise.