$tarrBuck Report, July 2, 2006: Interest Rates and Home Prices

July 2, 2006

$tarrBuck Report July 2, 2006

by R. M. Starr

Interest Rates and Home Prices

Mortgage interest payments are the price we pay for home ownership. It’s a cost even if you own your home free and clear: the money that’s tied up in your home could be out earning interest. There are two main ways to think of the interest cost: nominal and real. Nominal cost is how many dollars we need to pay each year. Real interest cost is the interest payment after subtracting out the rate of inflation.

If you’ve borrowed $200,000 at 5% interest it’s costing you $10,000 a year in interest. That’s the nominal cost. But if inflation is running at 3% a year, the purchasing power value of your debt goes down by $6000 in the same time. It’s really costing you only $4000 a year, 2% real.

If that $200,000 is the value of your house and your house is increasing in value by 15% annually then the net cost isn’t $10,000 — you’re actually making $20,000 in profit on the year. The investment in your home is appreciating by more than the interest cost. That’s why home ownership has seemed like such a good deal for many years.

So once you’ve got your mortgage loan and can afford the payments, what really matters is two quantities: the real interest rate and the rate of gain in the value of the house. What you’re paying after the depreciation in the value of your debt or after the gains you’ve made on the house. But nominal interest rates matter too. They determine your cash flow situation: can you afford the payments right now? can you qualify for the loan in the first place?

Over the last five years we’ve seen a roller coaster ride in short-term nominal interest rates, and they’ve taken the housing market with them. The US central bank, the Federal Reserve System, embarked on a vigorous program of interest rate cuts in 2001 to cure a recession and forestall deflation (a general decline in the price level focusing on “core” prices, not including food and energy). That policy has been successful. It created a growing economy and a residential real estate boom.

It’s short-term rates (for borrowing under a year) that determine the interest rate on adjustable rate mortgages (ARMs). ARMs amortize over many years, but since the interest rate resets regularly, their interest rates move with short term rates. As ARM rates moved down from over 6% in 2001 to a trough of 3.4% in 2004 and most of the way back up in 2006, the mortgage market and the housing market have moved with them.

Borrowers who could not qualify for a loan in 2001 found that they easily qualified in 2004. An ARM that required a monthly payment of $1000 in 2001 needed only $600 in mid-2004. That change expanded the pool of buyers and the purchase price they could afford as current monthly payments went down. So housing prices went higher throughout the period. And rising prices feed on themselves: everyone wants to get on the bandwagon for the ride.

The rates on fixed rate 30-year loans have been pretty steady over 2001-2006. They’re about the same now as they were in mid-2001. So the conservative buyers who locked in fixed rates have little problem meeting their monthly payments.

But ARM rates bottomed out in 2004 and they’ve been going back up. Many potential buyers now who could easily finance their house purchases at 2004’s ARM rates cannot finance a similar purchase at 2006 rates. That cuts into the demand for houses by potential buyers. That’s why the housing market is currently slowing. And as it slows, the bandwagon effect works in the opposite direction. No one really wants to get on a ride that’s going nowhere.

So where is the housing market going from here? The opposite direction of where interest rates are going.
Forecast: There will probably be no crash in house prices until the next recession, but it will be a slow market for years. As ARMs taken out in the first part of this decade reset their interest rates in coming years, there will be some pressure on the owners to sell, creating a drag for years.

Advice to buyers: Fall of this year is likely to be a buyers’ market. A slow selling season in the Summer of 2006 should create bargains in the Fall.

Advice to sellers: Patience and decisiveness. It’s a buyers’ market. The sweet prices and deals that a seller could expect in 2004 won’t be around for many years to come. Expect to wait for a buyer, and sell when you can.

(c) Copyright R. M. Starr 2006

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