For much of this year the numbers have jelled very nicely and the result has been both rising home values and increased sales. Such outcomes have been made possible in large measure by the fact that interest rates have been largely below 4 percent, but unfortunately that does not mean such rates are in any way permanent.
If history is any guide then we mention what the history actually is: The usual mortgage rate during the past 40 years or so has been 8.6 percent according to Standard & Poors. That means our real estate market is now powered by mortgage rates which are less than half the norm seen by parents and grandparents.
But what if rates increase? How would that impact real estate sales? What would happen to home prices?
To answer these questions we need to consider several factors:
First, according to the Census Bureau the U.S. median household income was $51,939 in 2013.
Second, the typical down payment according to NAR is 10 percent. First-time buyers usually purchase with 4 percent down while repeat buyers can be expected to bring 13 percent to closing.
Third, to have a “qualified mortgage” or QM borrowers typically cannot devote more than 43 percent of their income to recurring expenses such as auto payments, credit card bills, student loans and housing costs — principal, interest, taxes and insurance (PITI).
As it happens the 43 percent debt-to-income (DTI) limit impacts a huge majority of all borrowers. The National Association of Realtors says that in the second quarter only 2.6 percent of all loan originations were for non-QM financing, mortgages which did not have to meet the 43 percent DTI standard. Seen the other way, 97.4 percent of all loans met QM benchmarks.
You can see where this is going. If our model buyers have an annual income of $51,939 they earn $4,328.25 per month. Forty-three percent of $4,328.25 is $1,861.15. If we subtract an estimated $100 a month for property insurance and $250 monthly for property taxes they have $1,511.15 remaining for mortgage payments — if they do not have any of those nasty recurring bills. At 3.9 percent, roughly today’s fixed rate for 30-year financing, they can get a loan for $320,384.
So far our buyers are doing very well because in August the median price for an existing home was $230,200 according to NAR.
If we leave our fantasy world for a moment and say that our prospective buyers DO have monthly bills then things change. If we set aside $200 a month for student loans, $250 for a car loan and $150 for credit card debts then we reduce our $1,861.15 by $600 to $1,211.15. Knock off property taxes and insurance ($100 plus $250 = $350) and $911.15 remains for mortgage principal and interest. At 3.9 percent our borrowers can now afford a $193,176 mortgage.
The principle here is always the same: Given a particular debt-to-income ratio — 43 percent in this case — any increase in defined costs such as student debt, auto financing, credit card bills, property insurance or property taxes reduces the dollars available for principal and interest. Going further, a higher interest rate is simply a cost with the same impact; it limits the ability of the borrower to qualify for financing.
The Fed & Interest Rates
For much of the past year there has been ongoing speculation regarding when the stars would align and the Federal Reserve would raise interest rates. The presumption is that if the Fed increases rates for banks virtually all forms of interest will rise, including mortgages. However, it should be pointed out that mortgage rates may not move in lock-step with the Fed because the Fed does not set mortgage rates and the banking system is now awash with capital.
For the sake of discussion let’s say that the Fed increases rates by .25 percent and that mortgage rates follow suit. Now our borrowers face a 4.15 percent interest rate so their maximum loan amount is lowered to $187,440. The quarter percent rate increase has reduced the ability of our model borrowers to finance by $5,736.
Is this a big deal? You bet. The borrowers now have less financing capacity so they have to cut back on any bid they might make for a home. Not only is this a problem for marginal borrowers, it’s also a problem for sellers because suddenly their pool of potential purchasers is smaller so they may have to lower their asking price.
The argument can be made that 4.15 percent financing is still less than half the rate seen during the past few decades, an average of 8.6 percent according to Standard & Poors. This is entirely true but for borrowers such an observation is merely an academic curiosity, the reality is that their ability to finance goes down with a rate increase. Because of the DTI limit any borrower who wants a qualified mortgage instantly feels the sting of higher rates.
If the Fed does raise rates it will perhaps start with a .25 percent increase and then, over time, try to move rates higher in an effort to head off inflation. If mortgage rates move higher, then the marketplace impact will be more visible.
For example, with a 5 percent interest rate a $911.15 monthly payment for principal and interest only finances $169,730 — a $23,446 drop from $193,176. At 8.6 percent — that historic norm — our borrowers can only afford a $117,414 mortgage. That’s a shocking $75,762 less than $193,176, our baseline figure.
Is there a reason why buyers might now rush to enter the marketplace as mortgage rates rise? Yes. We can expect that some borrowers will finance and refinance because they will want to catch rates before they rise further.
The Fed now faces more and more pressure to raise rates if only because it has discussed the idea so often. When it finally does raise rates the housing market will wobble, home prices in many markets will stall, and sale volume will drop. The Fed is keenly aware of this reality, one reason — perhaps — it has not raised rates so far this year.