News broke this past week that interest rates on mortgage loans rose to the highest they’ve been in 10 months. Interest rates on mortgages tend to follow the yield on ten-year treasury bonds, which spiked recently over concerns about inflation. The average rate for a 30-year fixed home loan now stands at just over 5%. It is good to see mortgage rates rising at last. It heralds the approach of a time when buying a home may once again actually make financial sense.
I’ve written about mortgage rates on occasion in the e-mail newsletter I used to publish before the launch of The Paper Boat, so for some long time readers this may seem a familiar topic. With news of rising rates, I think it is an appropriate one to revisit and bring to the blog now. This is a topic that is surrounded by misunderstanding, as the idea that higher rates make housing more affordable seems counter intuitive to many. Of course I am talking about buying property, not refinancing it. It is always best to refinance when rates are lowest, which in this case was about three to six months ago. However, in the big picture today’s rates are still quite low historically and this remains a better time to refinance than to purchase property.
Despite the drone of advice we hear to the contrary, the old investor’s adage “Buy low, sell high” does not apply to interest rates. These days we hear from the press and advertisers that we must take advantage of the opportunity to buy at low rates before they go up. This has been the much touted advice of the National Association of Realtors, which was the primary source of real estate analysis in the press all during the inflation of the housing bubble. Their message to buy while rates are low has been absorbed and circulated to the extent that now it just seems like common knowledge. You just need to keep in mind this is the same group who’s Chief Economist at the peak of the bubble in 2006, David Lereah, advised that housing would only continue to go up in value exponentially… forever… right before the bubble popped and everyone was thrown into foreclosure and bankruptcy.
Ooops. Later when interviewed for an article in Money magazine in 2009, he admitted he was just trying to sell houses.
“I worked for an association promoting housing, and it was my job to represent their interests. If you look at my actual forecasts, the numbers were right in line with most forecasts. The difference was that I put a positive spin on it.”
I have a neighbor who has been successful investing in real estate and managing properties. A couple of months ago she asked me if my husband and I are intending to buy property. I told her we were hesitant to buy with real estate still so overpriced and the economy so unstable. She looked at me with pity and suggested with a sort of polite intensity, “You should REALLY look around now if you want to buy. Get pre-approved. The interest rates are the lowest they’ve ever been and I’d hate to see you miss out on this opportunity.” She explained how she’d bought a multi-unit building in the 1980’s, when mortgage rates were up near 18%. That meant the interest on her loan would end up adding a huge chunk to the overall nugget invested on the property, though in fact she did manage to refinance and bring the rate down later. What she failed to factor in is that she bought the property for 80% less than what you’d have to spend buying it today. This steep incline is not due to normal price growth in real estate, but to the lingering inflationary effects of an unprecedented and unsustainable housing bubble that grew out of historically low mortgage interest rates.
Herein lies the crux of the paradox. The interest rate does not act independently to add a layer of extra cost to the purchase of a property. It is a variable in an equation. Contrary to the irrational thinking so prolific during the housing bubble, there is actually a limit to what people can afford when purchasing a home. This limit is directly tied to their available income. So there is a lid to what a seller can ask for a particular property, which is determined by what the pool of potential buyers are willing to pay for it. (Supply and demand!) Because there is a limit to how much a buyer can spend on a property, if the amount going toward interest moves higher the selling price is forced lower. This works in the reverse as well, which we saw illustrated perfectly in the run-up in prices during the housing bubble. As Federal Reserve policy artificially forced interest rates to historic lows, housing suddenly became more affordable. Sellers quickly realized that with the discount this provided to buyers they could easily demand more in their asking prices, which pushed home prices up. So basically when interest rates are low prices rise, and when interest rates are high prices drop relatively.
The appeal of the low interest rate for most is that it makes monthly payments lower. This should not be a consideration when calculating whether or not a property is affordable, but it has in fact become the number one consideration for many people entering the market. In our credit-dependent culture we have come to assess our finances in terms of what seems affordable on a month-to-month basis. This is a mistake. What happens to a house that is purchased when interest rates are low, as they are today? It becomes worth less as rates inevitably rise later. Equity is stripped and the option to refinance may eventually become impossible. In the wake of the housing bubble we are seeing a huge percentage of mortgages underwater – where the buyer is now paying more for the house than it’s worth on the current market – and that number is growing. When a house is underwater it becomes ineligible for refinancing. Where I live, in Los Angeles, we’ve seen a 50% loss of value in many cases since the bubble peaked. People who bought then are paying twice what they should be at this point. Their equity has faded into thin air. As interest rates now begin to rise in an already deflationary climate, they’ll be able to sell for less and less and more homes will fall into foreclosure. It’s a trap.
If loan cost = price + interest and the loan cost is a fixed value, price and interest must move relative to each other.
Reasons to buy while mortgage interest rates are high:
* Prices are forced up as rates go down, and you gain equity and value
* A low priced home can be refinanced later when rates inevitably cycle to a low point again
* As an investment you can sell later when rates go down and prices are pushed high
* In most cases taxes will be assessed and locked in at a lower rate, due to lower price
* If you have PMI (insurance required with a down payment less than 20%) it will be paid off faster as equity grows faster
Reasons to avoid buying when mortgage interest rates are low:
* High price can only go down and you lose value and equity
* You cannot refinance if underwater
* Risk of becoming trapped and unable to sell
* Trapped at higher tax rate
* PMI payments may be extended as equity is lost
Most serious investors know the time to buy is when rates are high. High rates reflect a market where there is demand and the potential for growth. Buying when rates are high and prices are low leaves the wiggle room needed to remain flexible during tough times. Low interest rates mean there is little demand for the product you’re investing in and a higher risk that the investment will go sour. Low interest rates are really just an incentive to get people to buy something that doesn’t smell quite right. Remember, when you buy a home at a high price that transaction is fixed forever, but you can always refinance the high number in the loan cost equation when you buy a low priced home with a high interest loan.
Era of Super-Low Mortgage Rates Appears To Be Over
Michelle Conlin and Janna Herron
February 10, 2011
Confessions of a Former Real Estate Bull
January 6, 2009