I showed a home yesterday to a very analytical gentleman.
Many of my clients are numbers people; real estate investors, engineers of all stripes, IT guys, business owners, a former trader on the Chicago Mercantile Exchange, a current international investment banker, and similar people who appreciate my highly analytical approach to managing their buys and sells of real estate.
The gentleman yesterday believes that inflation is building and that although home prices in his area may decline a bit more, any such decline will be more than offset by increasing interest rates caused by inflation.
That is, he believes the downside risk of home prices is less than the downside risk of interest rates so he wants to buy soon.
I mentioned that some believe that after the U.S. presidential election the Federal Reserve will be more likely to increase interest rates but he hadn’t used that idea in his calculations.
Let’s see how this idea plays out.
Let’s say you take out a 30-year mortgage for $200,000 at 6.0% interest. The monthly payment will be $1,199.
- At 6.0% interest, $1,199 a month will get you a 30-year loan for $200,000.
- At 6.5% interest, $1,199 a month will get you a 30-year loan for $189,695.
- At 7.0% interest, $1,199 a month will get you a 30-year loan for $180,219.
- At 7.5% interest, $1,199 a month will get you a 30-year loan for $171,478.
- At 8.0% interest, $1,199 a month will get you a 30-year loan for $163,404.
What is your expectation for interest rates?
{ 10 comments… read them below or add one }
Brian McMorris 08.28.08 at 5:54 pm
Actually, I think interest rates are maybe more likely to drop rather than increase, if current global economic trends continue. The US credit markets are beginning to show more signs of stability. Some of the frozen derivative contracts on the banks’ books are beginning to move, albeit at cheap prices, but at least there is a market for the paper. The Fed is orchestrating much of this by its Fannie and Freddie backstops, plus its orchestration of other regulatory institutions to get out and do workouts with their regulatees.
An example is the FGIC workout by the NY state insurance commissioner, Eric Dinallo. He arranged for MGIC to buy some of FGIC’s muni insurance paper at a deep discount. By doing so, it increased MGIC’s capital and improved FGICs credit rating, allowing it access to capital and the ability to take on new policies. Both players were aided by the regulator’s actions.
There are similar stories at Lehman and other banks. As the market becomes more calm, the huge spread between the 30 year fixed mortgage market and the treasury market, now at over 2.5%, should shrink back to its normal 1.5% relationhip. Once this happens, and assuming the Fed keeps 10 year Treasury rates low to allow for a complete repair of credit markets and the economy, 30 yr fixed mortgage rates should drop to 3.8% + 1.5% or 5.3%.
I don’t think raw materials inflation will continue for the present. The globe is going into synchronized recession. Europe is getting hit hard right now, which is helping the dollar and raw materials costs. With lower global demand for materials, prices will decline. When paired with the previous housing deflation, the pricing indexes are more likely to hold steady than they are to accelerate upward.
Once the world economy gets better, maybe 18-24 months from now, then the case for some amount of interest inflation is better. But I think housing prices will stop declining before interest rates begin climbing. There is a deliberate effort by people with the capability to make that happen.
John Wake - Real Estate 08.28.08 at 8:19 pm
I sure hope you are right about interest rates!
Wouldn’t interest rates in the mid 5’s be nice. I feel better already!
ks 08.28.08 at 8:50 pm
It would be better to buy a house for
(a) $163,404 at 8%
then to pay
(b) $200,000 at 6%
for the same house.
Your down payment is larger percent under option (a). Also, if interest rates EVER go down, you can refinance at the lower rate.
It is counter-intuitive, but the truth is that higher interest rates can be good for the home buyer.
John Wake - Real Estate 08.28.08 at 8:54 pm
ks,
Wow! That’s a point I NEVER considered.
And a very good point it is.
You know, I think I just decided to be happy no matter what happens!
krogers 08.29.08 at 11:09 am
Ks nailed exactly what I was going to say. You can’t change that bottom line, but you can always refi. I also like Brian’s analysis, and it gives me hope. Playing that game of rates vs prices is certainly unknown, but I think we can predict where the rates might head based on the information he provided.
I also think that with stricter lending policies, it’s making it harder for people to get loans. Banks are in a tough position where raising those rates will mean even less lenders for them, but they don’t want to lower their long term loans now, since the only direction the fed rate can go at this point is up. Man, 5.3% would be amazing though!
Yelanda 08.29.08 at 1:02 pm
The way I understand John’s original comment is this is only the fact of the interest rate vs mortgage payment $amount. It doesn’t mean that the higher the interest rate, the cheaper the properties are. Well, it could be, but it may not be in proportion.
Back in the Dot Com bubble, interest rate went up, so did property prices. And when the Fed lower the rate last year, so did the price.
I am a true believer of the law of demand and supply.
Brian McMorris 08.30.08 at 11:55 am
Yelanda, both arguments are correct. Housing prices (and every market price) is set by supply and demand. But all things being equal and supply and demand the same over two different periods of time, the interest rate will affect the housing cost by the amount of the mortgage payment. To maintain the same mortgage payment at the same supply and demand, a higher interest rate would require a lower house cost or amount of principal.
During the Dot Com bubble, demand was higher than supply, so prices went up. With more money in the economy due to high capital gains, interest rates went up.
In the past couple of years, housing demand was quite low and supply quite high, so home prices went down. However, mortgage interest rates have stayed flat to rising even though the Fed dropped its Fed Funds rate to try to bring interest rates down (to put a floor on prices as you suggested). This was due to stress in the credit system and the higher risk premium placed on home mortgages. So, house prices have come down even faster than forecast to compensate the higher than expected mortgage rates. This also shows the limits of Fed power.
ksroger 09.01.08 at 6:36 pm
Which is why I like John’s analysis of the Fannie Mae and Freddie Mac deal. The gov tried to bring a sledgehammer down on the interest rates but banks didn’t pass the savings on, due to the reasons Brian stated. However, with more push on Fannie and Freddie, I bet they can set the rates that other banks will follow suit on, instead of just trying to lower the fed rate.
Aaron 09.02.08 at 7:17 pm
High inflation means low interest rates…..I’m not sure how inflation raises interest rates….but I’ll take low prices and high interest rates any day of the week. FHA, Freddie and Fannie are the worst things to happen to the housing market (but they are good for Realtors). All these companies do is make it easier for people to get loans, so more people are able to buy, so prices increase….supply and demand. However, if there are too many government bailouts the bond market will “no likey” and cause interest rates to skyrocket. But the artificially low rates we had the past 5 years caused house price inflation and got us into the mess we’re in now.
Brian McMorris 09.04.08 at 12:08 am
Aaron, interest rates are greatly influenced by inflation, or more precisely, inflationary expectations. Lenders demand a return on their invested money. That return needs to be above the rate of inflation, or in essence, the money would be lost over time.
There is a term called “Real Rate of Return”. This is the interest rate minus the inflation rate, and is really what any investor or saver cares about. This is why putting your money in a bank account to save is such a bad idea. Passbook savings interest rates rarely exceed the inflation rate, so such a saver is constantly losing purchasing power on saved dollars.
Some economists have postulated the “normal” real rate of return to be 2.50%. This can actually be validated by the TIPS inflation protected Treasury products. 2.5% does seem to be the average after inflation rate on those products (the rate is set by auction, so varies over time).
Regarding your Fannie / Freddie interest rate observation: yes, from 2003-06 the bond markets “too much likied” the FNM and FRE bonds, which was why interest rates were so low. Too much money chasing too few goods (bonds) pushed up bond prices, which pushes down yields or interest rates. Blame the foreigners, that always seems to work ;o)