Home Ownership Costs: What happens when mortgage rates rise?
Low or falling mortgage interest rates are better for housing costs than high or rising rates.
From a consumers point of view, higher interest rates are bad because borrowing money becomes more expensive. All things being equal, higher mortgage interest rates make for a higher cost of ownership and visa versa. When actively looking to purchase a home, shopping around for the lowest rate can save thousands of dollars over the life of the loan. The Consumer Financial Protection Bureau launched a Rate Checker to help consumers verify if the rate they are quoted is good or not.
Since rising mortgage interest rates makes borrowing more expensive, it’s also detrimental to home prices, so nobody in real estate relishes the idea of higher mortgage interest rates.
In a previous post I discussed the four variables that determine the purchase price of a property:
- borrower income,
- allowable debt-to-income ratios,
- interest rates, and
- down payment requirements.
Today we look at interest rates.
Interest rates are the yield on debt instruments. If investors lose their appetite for mortgage debt, prices of mortgage-backed securities go down, payment yields go up, and mortgage interest rates go up with them. The Federal Reserve heavily influences the yield investors require by adjusting the Federal Funds Rate, the base rate all yields are compared to.
What happens when interest rates rise?
The big fear many people have is that mortgage interest rates will rise back to historic norms of 8% or go even higher. There is no question that higher interest rates make for lower loan balances. If this were not true, the federal reserve wouldn’t have purchased mortgage-backed securities to lower interest rates. The math is inescapable.
At today’s low interest rates, borrowers can comfortably leverage over five times their yearly income. The long-term average for interest rates is 8%-9%; at those interest rates, borrowers can only leverage three times their yearly income. The old rules-of-thumb about borrowing three-times income are relics of a bygone era. But what happens if those interest rates come back? Three point five percent interest rates are not a birthright; in fact, interest rates have only been this low one other time in the last two hundred and twenty-two years.
As is evident in the very long term chart of interest rates above, the interest rate cycle is very long. During the cycle of rising interest rates, central bankers raise interest rates to combat inflation and protect the value of the currency, but they are always one step behind. When Yellen finally does start raising interest rates, we will be embarking on the next multi-decade rising cycle where inflation is a constant problem. The fact that inflation is not a problem now is primarily why I don’t believe interest rates will rise in 2015.