Record Low Mortgage Rates Make Now a Terrible Time to Buy a House
All things being equal, lower mortgage rates make buying a similarly priced house more affordable. The problem is that things are no longer equal.
The widely subscribed to "low mortgage rate" axiom is based on a set of conditions that defined the U.S. housing market for 70 years. For three generations following The Great Depression housing prices rose steadily and, more importantly, did not decline in value.
In an environment where capital and equity losses do not occur, a mortgage rate is the only cost of servicing homeownership on an equivalently priced house (excluding maintenance expenses).
Since the Housing Bubble collapsed prices have been falling. The conditions which made lower mortgage rates relatively valuable to buyers have largely evaporated. But the adage remains and has been exploited brilliantly by the Federal Government and National Association of Realtors. Policy makers have been subsidizing mortgage rates for 18 months in a failed attempt to prop up the housing market, while NAR has marketed these low rates to malleable buyers to generate broker commissions.
In the current environment record low mortgage rates are of secondary importance when calculating the cost of homeownership and represent a discrete reason not to buy a house.
Reason #1: Falling Prices Make Mortgage Rates Largely Irrelevant
Buying a home because mortgage rates are low is like buying a stock to take advantage of an attractive margin rate. There is nothing wrong with making such a purchase if the stock has solid fundamentals and its price is stable or appreciates. But if the stock price falls, this secondary source of value is of little consolation as leveraged equity losses overwhelm theoretical interest rate savings.
Housing prices have been falling for years and are likely to continue to depreciate, despite record low mortgage rates, because:
- Valuations remain above the historical trend line and pre-bubble levels
- ARMs will relentlessly reset and trigger foreclosures through 2012
- The housing market is defined by high inventories and a growing number of distressed transactions
- Unemployment is elevated
- The financing environment is incapable of supporting current home valuations even with extraordinary Government subsidies
Mortgage rates are largely irrelevant in an environment where housing prices are overvalued and declining because leveraged equity losses quickly overwhelm theoretical interest rate savings. Given that prices are falling and likely to decline in the future, the relative advantage of lower mortgage rates is reduced or eliminated.
It is preferable to buy a fairly valued home, that is not declining in price, with a relatively high mortgage rate than it is to purchase an overpriced house, which is falling in value, with a record low mortgage rate.
If this logic does not resonate consider the Housing Bubble.
A Recent Lesson Not Learned
During the mania portion of the Bubble buyers had access to introductory and teaser interest rates as low as 1%.
It is for this reason that today the lowest fixed mortgage rates in U.S. history have failed to halt price declines. Current marginal rates are much higher than those which were accessible during the Housing Bubble. Prices were inflated and supported by these teaser rates. Even record low fixed rates are insufficient to support adjustable mortgage valuations.
Introductory teaser rates were also supposed to be a bargain. Unfortunately for buyers home prices declined and leveraged equity losses eradicated theoretical mortgage savings. Many of today's foreclosures result from people who subscribed to low interest rate mortgages but are now hopelessly underwater. As these adjustable loans reset, sub-5% fixed rate mortgages are available, but equity losses have dwarfed interest savings and produced defaults.
If 1% introductory mortgage rates were insufficient to make homes a profitable investment in an environment where prices were falling, how will 4.8% fixed rates accomplish this feat? This leap of logic apparently eludes many homebuyers, but a 0% mortgage is a terrible deal if the value of the house purchased declines materially.
House prices in Chicago are down 10% over the last 6 months. Buyers must be ecstatic they were able to lock in a 5.06% fixed rate mortgage in September of 2009.
Reason #2: What Happens When Mortgage Rates Rise?
Subscribers to the adage that low mortgage rates make it a good time to buy fail to consider an important question. What happens to prices when mortgage rates inevitably rise?
As observed, fixed mortgage rates are at the lowest level in history, but prices are not rising nor have they even stabilized. Prices continue to drop despite the relatively lower cost of servicing a 30-year mortgage.
Prices have been and will continue to fall because they are overvalued. Low mortgage rates, which reduce the cost of servicing ownership, do not change this reality. Prices are falling less rapidly as a result of low interest rates, but they are still falling.
So what happens when mortgage rates rise? The obvious answer is that prices will fall.
The Future of Mortgage Rates
The Federal Reserve spent $1.25 trillion over 18 months subsidizing mortgage rates in a failed attempt to prop up prices. This effort recently expired.
When the Fed suspended its purchases of mortgage securities the Obama Administration directed Government Sponsored Entities to pick up the slack. In the first quarter an incomprehensible 96.5% of mortgages issued were backed by the U.S. government. Fannie Mae, Freddie Mac and FHA guarantees have transferred the risk of massive mortgage-related losses from investors to taxpayers. By transferring this risk and eventual losses to the Government, policy makers have maintained a robust subsidy and kept rates at record lows.
Market determined interest rates represent a required rate of return on capital given the perception of risk. Today it may be credibly argued that housing has never been riskier.
- Prices have been falling for years and are likely to continue to fall.
- Housing as an asset class has never been more leveraged
- There is almost no private sector market for mortgages. Housing is being propped up entirely by Government subsidies
- Valuations are lower today than 4 years ago, but the perception of risk is much higher
Given the risks associated with financing a home purchase, one would expect mortgage rates to be high or rising. Instead rates are at the lowest level in U.S. history solely due to Government command economy edicts.
At some point these subsidies will end and the private market will again finance mortgages. Politicians in fear of ouster will cease committing taxpayers to mortgage losses, a voter/taxpayer revolt will force the hand of policy makers, or the capital markets will punish this unsustainable behavior via higher interest rates, a credit rating downgrade or reduced access to capital.
Regardless of circumstance, higher mortgage rates are inevitable.
NAR Markets Cliff Diving to Lemmings
The National Association of Realtors has advertised the temporary nature of record low mortgage rates as motivation to purchase a house now. But it is exactly the temporary nature of low rates that should scare off potential buyers.
In an environment where houses are overvalued and declining in price, record low, subsidized and unsustainable mortgage rates are a reason NOT TO BUY a home.
The National Association of Realtors has misled a generation of house buyers using an adage that no longer holds true.
Dismal Reality
1. In an environment where houses are overvalued and prices are falling, low mortgage rates are largely irrelevant when considering the cost of homeownership relative to leveraged equity returns.
2. In an environment where prices are prone to fall, purchasing a home when mortgage rates are at a record and unsustainable low (especially when those rates result from Government subsidies) is a terrible idea because mortgage rates will inevitably rise. When rates rise, housing prices will fall, creating capital losses which overwhelm perceived interest rate savings.
Whitney--
Agreed, for the most part. I cringe every time I hear most NAR solicitations. However, in my opinion there is one disconnect in your analysis. The argument that "low fixed rates are a terrible deal if the value of the house purchased declines materially" is not valid IF one doesn't care whether the value declines. And this can manifest itself in two ways-- first, if someone plans to stay in the house for the long term, and ride out any price volatility (though even here, I admit that one might be concerned with a mostly paid off house whose value after 20 years is still less than the price paid).
Second, one might not care about the price depreciation if the degree of leverage is so high that walking away from an underwater house does not present the borrower with any financial pain. To use your stock analogy, if you were able to not only get a good margin rate, but also finance 99% of the cost of the stock, you would be able to benefit immensely from any appreciation in the stock price. If the stock value declined, however, you might be inclined to hand over the devalued stock to the margin lender, since the consequential loss of your 1% equity share is not material.
Of course, this argument assumes that lenders will not pursue defaulting borrowers for deficiencies which remain after default. As you know, this assumption isn't far off in today's market-- lenders are either prohibited from pursuing deficiencies by state law, or encouraged by government policy to modify loan terms and thus sustain losses, or the foreclosure process is so cumbersome that lenders may not choose to pursue it, or if they do, may fail. (I know a lot about this last one, as many of my recent attempts to collect deficiencies on behalf of lenders have not survived challenges provided by the legal system).
All that said, the reason I make this observation is that the extremely high LTV levels that, even in today's market, are still deemed acceptable by GSEs (most notably the FHA), may cause your thesis to be wrong. If I can borrow 99% of the purchase price, and the cost of servicing my debt is artificially low due to the historically low, government-manipulated interest rates, WHO CARES if my home value declines? I'll just walk away! At that point, I'll only have paid a low imputed rent for my house while I was in it. For that reason, if I could maximize my leverage, I would think that the NAR's claim about low interest rates being a good reason to buy a house was valid (though not for the reasons they claim).
Hopefully, the government will understand this, and either (i) raise interest rates, (ii) stop allowing GSEs to accept woefully low LTV percentages, or (iii) change the foreclosure laws to allow lenders to pursue deficiencies on defaulting borrowers with greater efficiency. Any one of these would have a positive effect on the situation, I think ...
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Response to comment posted as article.
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"So what happens when mortgage rates rise? The obvious answer is that prices will fall."
This is not true. As soon as mortgage rates start to rise, the realtor "lock in now" hype will begin. Demand will be created and prices will rise. This will happen as long as rates rise, as it has in the past, and will only stop when the interest rate ceiling is reached and stable for a while. The Fed would be wise to raise rates at a steady, measured pace over an extended period in order to maximize this effect.
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Ray,
I appreciate the comment but challenge your understanding of economics. When the price of borrowing falls, demand increases. When borrowing costs rise, demand falls. This is why the Fed and policy makers have slashed and subsidized mortgage rates. And to some extent it has worked. There are many forces which determine home prices, but marginal interest rates today are still much higher than during the Mania Portion of the Bubble (see ARMs) and as expected demand for housing is much lower.
You do articulately describe the conundrum of potential homebuyers in a world where housing prices do not drop. In a reality where they can and are falling, your logic is based only on rigid historical observations.
To the extent that NAR is successful triggering sales through marketing alone, those transactions will not be at a higher price, but at a lower one. Potential buyers today aren't waiting for rates to fall from the lowest levels in history... and they are certainly not waiting for rates to rise in order to buy.
I further note that demand created by NAR marketing over the past 4 years related to "more affordable housing", tax rebates and low mortgage rates have failed to stop housing prices from falling. The number of sales may have been manipulated by NAR but economic conditions
Reality is that valuations today are unsupportable even at record low fixed interest rates, which is why they are falling. Even if the number of transactions increased temporarily due to marketing or individual concerns over missing out on low rates, prices would still fall unless fairly valued.
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Yes, my comment is based on historical observation, which I put more credence to than rigid calculations since those calculations don't take human nature into account. What we have in this country is a situation that the Fed and other holders of large qty of MBS can capitalize on: relatively lower house prices; a lot of folks waiting in the wings for prices to start rising again so they can get back on the appreciation escalator; and historically low interest rates. At some point, very soon according to statements from some Fed members, interest rates will rise not to control inflation but to head-off the next speculative bubble. My contention is that it will be critical HOW the Fed raises those rates. If they go from 0 to 4.5% overnight, then I agree with the economic calculus of lowered house prices. But if they raise them gradually, so that people see it happening and realize they need to lock in a low rate ASAP before the next increase, then housing demand will increase and thus prices, independent of the rate calculations. Your statement that when rates rise demand falls, and vice versa, is too simplistic and just doesn't jibe with the realities of human nature or historical observation.
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You can only pull forward so much demand. I agree that when rates go up people will try to lock in, but only a certain amount. When rates go even higher nobody can afford the payments and prices will drop. Its really all about income, my view is that median income can afford median house. If income growth can keep up with inflation and interest rates then prices won't drop. And since real income has been dropping for like 10 years I don't see incomes keeping up with rates.
Just my 2 cents.
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Ray,
Question: why would buyers wait for rates to RISE before locking right now while (1) rates, conforming qualifying standards and down payment requirements are at the lowest levels in history and (2) most markets are technically recovering even according to Case-Shiller?
Answer: the class of buyers targeted by such incentives has been completely TAPPED, pushed forward by tax credit schemes. This is why mortgage purchase apps have declined 35% in the past month despite record low rates. (http://www.calculatedriskblog.com/2010/06/mba-mortgage-purchase-applications_09.html)
Even to the extent that your proposition is borne out, the 'demand creation' would be limited in scope to the most rate-sensitive buyers (i.e. non-savers). For this class of buyer, the rates largely dictate 'exactly' how much they can afford. Although they may have 'desire', they have reduced means with which to 'bid'.
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It's not that buyers would wait for rates to rise. What they are waiting for is for consensus prices to rise enough for them to feel comfortable there will be no double-dip.
I disagree that demand in the "slowly rising rate" scenario would come primarily from the most rate sensitive buyers. It's true they are the ones who would initially need to purchase to avoid being locked-out, but ALL buyers who are now on the sidelines will respond to rising rates in the same way, as they did in the last several recoveries.
The Fed won't raise rates if it means housing prices will fall, period. That scenario is a non-starter because it would further undermine their ability to off-load the MBS on their balance sheet and those of member banks. They will wait until prices are firmly rising, couple this with very positive statements about the recovery, and then start a "slow burn" increase toward the target 4.5% Funds Rate. The resulting demand creation will support the price rise and then and only then will they be able to offload MBS effectively.
By the economic logic of the article, as rates were dropped from Sep06 through Dec07, house prices should have risen, but they did not because there was little demand to buy in a housing bear market.
Imagine you are one of the millions of folks who have been holding back purchasing a house because of the crisis. You have your eye on some potential candidates, and are pre-approved for a loan, but you are just not confident enough in the economy to pull the trigger and risk a loss. Then one day you hear that the crisis is over from the national media, and that there is no risk of double-dip. Interest rates are still at historical lows, but you are still worried that there is some risk, demonstrated by the fact that the Fed is still keeping those rates so low (this is where we are today). A week or two later, you hear that the Fed has raised interest rates 0.5% because of the need to head off inflation-inducing speculative bubbles due to the rising economy. You panic, because your pre-approval is now in jeopardy, and you rush to buy at the old rate, but no dice and you have to lock in at the new rate. You can't afford as much as you could before, but you know you need to buy NOW to avoid higher interest payments from the next increase. You are not thinking "this is great! house prices were rising, but now that interest rates are rising the house prices are going to fall again and I'll be able to afford an even bigger McMansion!". No, you are thinking "I need to buy NOW or I am going to get locked out of the home of my dreams!". So you buy, and so do many others in the situation. And those who waited too long see that multiple offers are pushing up prices quickly, and interest rates are probably going to rise again, and they better get MOVING or they will get priced out of the market! And the bull market is again in full swing!
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Ray,
According to your theory, both the Fed and millions of potential buyers are not going to act "until prices are firmly rising". Note to Bernanke: you might as well take a well deserved vacation until the housing market gives you your marching orders, since your hands are (allegedly) tied.
Since you've squared away the idea that basically nobody is going to act until prices stop falling, we best turn our attention to what exactly is going to bring that about, since tax credits and record low interest rates, conforming standards, and down payments can't cut the mustard.
The answer, backed by both logic and "historical observation", is: Affordability. Prices will continue to decline until their fundamental value is reached, i.e. when renters can buy the home they are currently renting with a monthly mortgage that is CHEAPER than their rent. That is what you call 'real' incentive, even in the face of a marginally declining market.
Once this level of rational (as opposed to speculative) price support is reached, the market will still take years to bottom (see 'historical observations' of prior bottoms). That means buyers have no reason to PANIC, GET MOVING, or BUY NOW. Although I don't agree, according to you it also means Bernanke will not raise rates during this long, bottoming process, but even if he did jump it up .05%, what do I care? It just means the seller is getting a 3% lower bid.
The home of my dreams is a cashflow positive investment, not a speculative, extremely rate-sensitive purchase I can (by definition) barely afford.
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Yes, that is my theory. Many feel the Fed won't raise rates until well into 2011 or even 2012, though some at the Fed think this will be too late and are willing to chance a double-dip to reign-in the other bubbles that have formed due to low rates and QE. But if the double-dip happens and causes house prices to drop further, the results could be devastating and I contend the Fed will not chance this.
I never said that "basically nobody is going to act until prices stop falling". Keep in mind that many, many people continue to buy houses, especially existing ones, and did so even while prices were falling. The national sales rate is above 5M/yr, which is about the same rate as 2001 and is "only" about 28% below the all-time peak in 2007. Many people forget this and think of the market as stagnant, but in reality it is only a little slower than normal. It won't take much increase in demand to reignite it.
Affordability would certainly be a nice thing but is not really necessary to generate demand. People are still very willing to buy beyond their means, and banks very willing to let them, as long as there is someone willing to take the loan off their books.
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Ray,
On the last paragraph, you are basically describing me as one of the millions who is ready to buy, pre approved, etc. We HAVE been hearing that the recession is over, the bubble is done and the house market is about to pick up and the rate is the lowest for a few months now!
You actually think that a house that is 3 times our gross salary (my household income is $150K, I use 3x as a healthy multiplier for anyone to buy a property) is consider a DREAM HOME? Try something that definitely need a touch of TLC, in my tri-state New York area.
To make it on the funny and light side, we are all have been somewhat a victim of HGTV, we have upgraded our "want" list. So, anything that is listed at 4x (600K) our yearly gross would be in our "great list" but far from DREAM home.
I read that for every 1% the rate goes up, my affordability goes down almost 20%. Now if I don't like the condition of the $450K house, do you think someone who earned 20% more than me would like to buy something that is $90K cheaper? I'm sure my calculation is not quite correct, but I hope you get my point. Nothing in NYC at $450K is anybody's dream home, unless someone loves a glorified top of the line studio in Queens.
Now, how many of those who waited because they actually knew there was a bubble that has not quite burst all its air yet, will actually jump the gun as if they didn't become a more cautious buyer to begin with? Those wise millions who are waiting will rather miss the first wave just to make sure that this is the bottom. We are not here to make a killing, just to make sure our biggest investment is solid. I also bet that those millions (including myself) are not the first in line to buy our iPads. We'd rather pay 1/2% higher to get better sleep at night.
That's my opinion. I'd like to read your reaction, please.
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Let's say that you start to see prices rise again (say be 5%), and then the Fed starts to raise rates (say by 1%). What will you do? Wait for the next bubble to burst? How much appreciation are you willing to give up, and how much higher payment are you willing to make?
I'm with you on not being the first to jump in. I am not one of the 5M/year buying houses right now, and won't be until I am pretty sure I am not going to lose 10% or 20% of the $1M I would have to pay for a decent (not dream) home here in the SF Bay Area. I bought my first house in Dec 1995, and sold in July 2005. Both purchase and sale were timed by changes in employment, not any knowledge of the markets, but I was pretty lucky, and I have not purchased again (yet).
I am a firm believer that we will indeed have a double-dip, and that this discussion will need to be continued in 6-12mos time. But eventually the time will be ripe for the rate hike that will come, and I will bet anyone that when it happens home prices will not fall...
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Ray,
You have been offering conflicting statements making your position almost impossible for me to understand, but on review of all the statements I've finally figured it out.
You took issue with Whitney's idea that increasing rates would cause prices to fall. Initially you stated, "As soon as mortgage rates start to rise... Demand will be created and prices will rise." This implied a rate move to precede and cause a price increase, which nobody agreed with. The next day you reiterated the view, "if they raise them gradually... then housing demand will increase and thus prices."
It is clear you were arguing that prices would be CAUSED to rise due to a gradual rate increase that would happen FIRST. To this effect you also said, "At some point, very soon according to statements from some Fed members, interest rates will rise." You offered the idea that rates would rise "soon" without mentioning anything about the status or direction of home prices.
However everything you said after that presupposes that prices are already "firmly rising".
This is a huge difference.
In fact it is the exact opposite of the context in which the ENTIRE article is based, i.e. on FALLING PRICES.
I suggest you reread the entire article, carefully.
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I re-read the article and I understand your point. The article is based on falling prices, and my various responses seemed mixed. I don't believe they were inconsistent, but were only considering different hypotheticals.
The primary scenario that supports my theory is if rates are increased only after house prices start to rise. But I don't believe this is absolutely required for my theory to be true, given the right marketing by the Fed, the administration, and the media. There still are 5M houses sold per year, in a flat to falling market, so it would not take much "hype" to generate demand again. Rising rates could easily be leveraged to create this demand and turn the market around.
If the Fed decides they need to raise rates in a flat to falling market, they had better figure out how to generate this demand or they will cause more problems for the economy.
The problem I have with the original statement "so what happens when mortgage rates rise? The obvious answer is that prices will fall" is that it does not properly take demand into account. It presumes that higher loan service due to the higher rate reduces demand, and my theory is this is incorrect and that demand can be increased by optimizing the rate trajectory. I would even be willing to bet that if rates were increased (slowly) NOW, in the flat to falling market, that it would generate demand and turn the market around. You can be sure if they increase rates in this environment, the Fed will be betting on my side.
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We are talking about confirmation buyers. Or if too late, better know as bag holders. I dont think that will work too dramatically again, when we start talking more than 1 a point increase.
Several reasons:
1. Previous crash leftover market psychosis
2. Pending tax increases - limited disposable
3. Unemployment - limited buyers
4. Capital wipeout - limited buyers
5. Many regional markets (Socal, Fla, Veg, NJ,) are still overvalued.
6. High inventories, ghost inventories, pending inventories.
7. Changing demographics (bubble shifting from investment into retirement homes/no more snow birds)
Could keep going.
I agree in gameplay there is a degree of confirmation/confidence market entry that macro theory doesnt account for. Thats why it is macro. I am personally in cash now, and waiting min 3 yrs before buying another home in North SD County.
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This is the finest and clearest article on American real estate history and current day reality that I have read during this entire mess of the past ten years. The sad reality is few will understand it, and worse some will be unwilling to accept these facts.
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You assume that there is enough political will to raise interest rates in this country. If Japan is any indication, I think interest rates will stay low in this country a long time. Debtors love easy money and inflation. And we are a country of debtors.
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Unless your house is PAID OFF--
You are either RENTING, or RENTING from the Bank.
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The biggest reason that now is not a good time to buy is that when interest rates rise, the monthly payment will rise, reducing demand / price. So the buyers today will be selling to buyers tomorrow who will have higher monthly payments stemming from higher interest rates. Those buyers will flinch and demand a lower purchase price and related monthly payment. The die is cast until housing prices move into a more historic relationship with income and interest rates rise about their current depressed / manipulated rates. We are in a pickle. Toad
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"When rates go even higher nobody can afford the payments and prices will drop."
Historically this has only occurred at the onset of a recession. As long as a double-dip is avoided, rates and prices are not tightly-linked. Once we go into the new growth cycle, it will be back to business as usual.
Now, if the Fed pulls the trigger on increasing rates too soon, and causes a double-dip recession because of it, then house prices will also fall and the rising interest rate would be correlated to the house price drops. But it is only a correlation, since the reason for the decrease was only indirectly due to the increase in rates, and directly due to the drop in demand caused by the double-dip.
The key here is as long as there is a housing market, ie people are buying houses at a fast enough rate to keep inventories down, prices will rise, or at least they will not fall. This is (one of) the reason that we got in this mess in the first place, ie few believed the market would collapse to such an extent that prices would fall.
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