Ownership cost: interest rates and down payment requirements
Four Major Variables that Determine Market Price
Yesterday, we 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 are looking at interest rates and down payment requirements.
Interest rates go up, and interest rates go down. Interest rates are the yield on debt instruments. If investors lose their appetite for mortgage debt, prices of mortgage-backed securities goes down, payment yields go up, and mortgage interest rates go up with them. This concept is important to understand because right now, the Federal Reserve is the main buyer of agency paper at price levels yielding 3.5%.
Private investors are demanding higher returns due to the risk of loss in a potential rising interest rate environment. The Federal Reserve feels it needs to step in to stabilize crashing markets by preventing an over-correction in risk premiums to make the free-fall worse. In crashing markets, 8% mortgage interest rates probably do not warrant the risk of default loss. The FED will retain this defensive market safety net until risk premiums and market mortgage interest rates get close enough to their support price that they can begin to unwind the program. It isn’t likely that private investors will return to buy mortgage debt at 3.5% yields any time soon, so the FED will have to be cautious in how it unwinds its supports.
This government intervention underscores the difficulty of forecasting interest rates and how fluctuations will impact the housing market. Think back to early 2008 when there when people still denied the housing bubble. Nobody imagined the Federal Government would assume ownership of the GSEs (at the time they were private companies), and that the Federal Reserve would be buying GSE paper at over-market prices. These unprecedented events would suggest a market cataclysm — the fodder of conspiracy theory nutters. Yet, here we are.
Interest Rates have a major impact on how much someone can borrow
Interest rates are critical because it determines how much someone can borrow. The same payment at different interest rates produces significantly different loan balances. When lenders calculate the size of the mortgage a borrower can sustain, they plug in the interest rate and the maximum payment (calculated by applying maximum debt-to-income ratio to gross income). For example, if a borrower makes $100,000 per year, the lender will allow them a maximum yearly debt-service of 31%, or $31,000. Divide that by 12 to get $2,583,33. Some amount is taken out for taxes, insurance, and HOAs leaving a remainder amount to cover a mortgage payment. The lender then takes that payment amount and plugs it into a formula to determine the maximum loan balance. At low interest rates, this amount is quite large, and at high interest rates, the supportable mortgage balance is much smaller.
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 be buying mortgage-backed securities to lower interest rates. The math is inescapable.
At today’s 3.5% interest rates, borrowers can comfortably leverage over five times their yearly income. The 40-year average for interest rates is 9%. At that interest rate, a borrower 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. Alan Greenspan presided over a twenty-five year period of declining interest rates. Much of the increase in value of real estate is attributable to decreasing borrowing costs over that time. Inflation was relatively tame, so Greenspan always had the luxury of lowering interest rates to increase economic activity. Those days are gone.
When the interest rate cycle reaches bottom, the value of the currency declines, and cost-push inflation becomes an issue. As Americans want to buy products from overseas, it takes more and more dollars to do it because the currency is declining in value. Unless we get a commensurate increase in our exports (or cheap money from China), our standard of living will decline. 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 Bernanke finally does start raising interest rates, we will be embarking on the next multi-decade rising cycle where inflation is a constant problem.
If interest rates go on a sustained rise, financing home purchases will become more expensive. That is the math. The real question then is whether or not these rising interest rates are compensated for by rising wages. If wages rise as fast as interest rates do, then borrowers will still be able to finance large sums, and house prices can remain stable or even rise. However, if wages do not rise as interest rates go up, then loan balances will decline, and house prices will fall again. Given the choice between inflation and falling house prices, which do you think Bernanke or a future central banker will chose? After the all-out effort they have made to prop up house prices over the last several years, I suspect they will chose inflation, a devalued currency, and steady house prices over a strong currency and falling house prices.
Down payment requirements
Down payment requirements have traditionally been very high. During the 1920s, interest-only loans with 50% down payments were the norm. Very few people owned their houses. By the 1950s, conventionally amortized loans with a 30-year term and 20% down payments became the norm, and house prices rose significantly from the bottom of the Great Depression to the 1950s due to the increased use of leverage in real estate.
That is the end of the road for financial innovation. All attempts to tinker with the stability of conventional financing have failed because they are all Ponzi Schemes. People must have a reasonable expectation of paying off a loan in their lifetime. Multi-generational debt is frowned upon here in the United States, so any term beyond 30 years really doesn’t make sense. If borrowers feel like they will never pay it off, they will not try, and they fall into Ponzi thinking and borrow in terms of maximum debt service. It is crazy.
By 2005, Option ARMs and 100% financing left us with 0% down payments as the cycle reached its ultimate limitation — they were giving it away. Not surprisingly, prices skyrocketed; unfortunately, the terms of the Option ARM were not stable and the Ponzi Scheme blew up. We are back to the 1950s in the world of mortgage finance — and that is a good thing.
The 30-year fixed-rate fully-amortizing loan is the only stable loan product, and a significant down payment is required to keep down speculation. As down payments get smaller, the incentives to speculate with lender money get larger. With no-money-down the incentive to speculate hits infinity. One-hundred percent financing with no qualification is a free-for-all no-limit housing market casino.
Savers gain advantage bidding on real estate
Most buyers don’t have 20% to put down on a home, particularly first-time homebuyers. Most buyers don’t have the current FHA standard 3.5% down either, or we wouldn’t have tried 0% down to begin with. When it is an FHA buyer, they generally only put the minimum 3.5% down. The loan plus the down payment is about 16.5% lower for an FHA buyer than it is for a conventional borrower putting 20% down, assuming both are qualified using the same income and same DTI. Further, the FHA buyer pays a significant insurance premium which cuts into their ability to finance a large mortgage. The same debt-to-income ration thereby supports a smaller loan balance.
In the real world, the conventional borrower is also utilizing a higher DTI ratio. Instead of being limited to the FHA 31% front end DTI, conventional borrowers are often allowed to go into dangerous waters with 32% to 38% DTI levels. This additional money put toward debt service makes for larger loans. The borrower with enough cash to put 20% down has a significant bidding advantage over the FHA buyer. The lower down payment amount and the smaller loan balance make FHA less desirable than conventional financing for borrowers looking to bid up prices. FHA financing can be looked at as training wheels for mortgage borrowers.
After some period of time in a normally appreciating market (if there is such a thing), the combination of loan amortization and home price appreciation results in home equity exceeding 20% of the resale value of the property. When there is enough home equity that a more expensive house than the borrower’s current home equity, they cross a threshold; they have access to the higher DTIs, and they can borrow more money to take the next step up the property ladder — if they are willing to give up some disposable income to have the house.
In the end, it is not the highly leveraged that gain the upper hand in real estate, it is the savers. The real estate market will always boil down to loan plus down payment. The more money people have saved, the greater their down payment and the more they can bid to compete with others at their income level. The saver always comes out ahead.