Jul072016

Fewer home sales or lower prices sure to follow higher mortgage interest rates

In the absence of rising wages, when mortgage interest rates go up, one of two things will happen: either sales will fall, or prices will fall. Since we don’t have a free market in housing, sales will fall and remain depressed for a very long time.

Assuming a consistent payment, higher mortgage rates decrease the size of the loan and reduce the amount borrowers can bid on real estate. While it is possible the federal reserve may print enough money to spark wage inflation, given the high levels of residual unemployment and a low labor participation rate, wage inflation is a long way off, almost certain to come later than rising mortgage rates. Therefore, if rising mortgage rates results in smaller loan balances, then either sales volumes will go down, or house prices will go down, or perhaps some combination of both. This isn’t speculation; it’s basic math.

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So which outcome seems more likely? If we had a free market without government and lender manipulation, prices would fall, perhaps precipitously depending on the market; however, we don’t have a free market, and our government, federal reserve, and a cartel of too-big-too-fail lenders are manipulating the housing market in an effort to drive up house prices. Since must-sell shadow inventory morphed into can’t-sell cloud inventory, I think it likely that home sales will be depressed for several years.

If we had cleared the market, hedge funds and other investors would have purchased millions of homes, and sales volumes would have been much higher. Of course, this would have bankrupted the banks, so another path was taken, but this path has consequences. If the plan is to sell these homes to owner-occupants and higher prices, then it’s going to be a long, slow slog, which is why 2014 and now 2016 disappointed for sales.enticed

The problem is affordability. Since most people borrow the max when buying a house (at least in California), then if mortgage rates rise to 5.5%, they won’t be able to borrow near as much money. Assuming prices remain constant, they simply won’t be able to afford to buy another home.

If mortgage interest rates rise to 5.5%, future buyers won’t be able to finance such large loans; therefore, they won’t be able to buy out today’s buyers allowing them to make a move-up purchase, or if they do execute a sale, it will be at a lower price, and the owner will obtain less equity (or none at all). Without the additional equity from a future sale, the people who own today won’t be able to leverage into a move-up home tomorrow at higher interest rates.

The problem is and always was affordability, and the long-term decline in mortgage rates has artificially improved affordability. (See: Housing market impact of 25 years of falling mortgage interest rates)keep_us_flying

For example, the average monthly interest rate from 1993 to 1999 was 7.63%. The average monthly cost of ownership was $1,538. That combination would finance a loan of $223,011. Add a 20% down payment, and the home price would be about $275,000 ($278,763 to be exact). Over the last 12 months, the median monthly cost of ownership in OC was $2,102. If you plug in that number in place of the $1,538 from 1993-1999, the resulting home price would be $380,089. The last reported median home price for OC was just over $500,000. House prices have been boosted about 30% due purely to the decline of interest rates from the mid 90s to today.

So now let’s assume mortgage rates will revert to the mean. What will a long-term rise in interest rates do to home prices? Interest rates must rise from about 4.5% to 7% to reach historic norms. If this happens over a 7 year period — which is a very gentle rise — rental parity will still fall from its current level even as rents and fundamental values rise. Since rental parity will serve as a more rigid ceiling on appreciation in the future, when prices rise beyond this barrier, it will serve as a major drag on appreciation.

In the absence of rising wages, when mortgage interest rates go up, one of two things will happen: either sales will fall, or prices will fall. Since we don’t have a free market, it seems more likely to me that sales will fall and remain depressed for a long time.

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