Higher mortgage rates were widely expected this year, but so far it hasn’t happened. That’s great, but will our good luck continue?
The real worry for real estate investors, property owners, and mortgage borrowers is that inflation above 2% might force interest rates higher. For much of the year this has not been an issue, but now perspectives have begun to change. The University of Michigan inflation expectation rate reached 3.4% in April, up from 2.1% a year ago.
There is a factual basis for such thinking. According to Trading Economics, the inflation rate was 1.7% in February, 2.6% in March, 4.2 in April, and a whopping 5.0% in April, the highest level in 13 years.
But, maybe the rising prices we’re seeing are not evidence of inflation.
According to Politifact, “economists said that most of the current rise in consumer prices stems from supply chains having to adjust quickly to greater economic activity after increased vaccination has eased the pandemic.
“Recent price trends for some basic commodities,” said the publication, “illustrate the ripple effect of the widespread business shutdowns that hit just a little over a year ago, and the resurgence of demand as vaccinations and declining COVID-19 case numbers promise a return to normal business activity.”
If it turns out that today’s higher prices are just a short-term blip that will be good news for interest rates.
What’s actually happening with mortgage rates is contradictory.
You might look at the recent inflation numbers and expect higher mortgage rates. But, nope, that’s not the reality. According to Freddie Mac the typical mortgage was priced at 2.74% in January, 2.81% in February, 3.08% in March, 3.06% in April, and 2.96% in May.
Even small changes up or down can be important. Lawrence Yun, Chief Economist with the National Association of Realtors (NAR), has said that “every 10 basis point rise in mortgage rates can shave off approximately 35,000 in home sales annually.”
Right now prices are up but sales are down, a mix that suggests affordability issues. Existing home sales have fallen for the past three months, while April new home sales dropped 5.9%.
“Affordability” reflects how easily the typical buyer can qualify for the typical home. Right now the situation is not good, and it’s getting worse.
The issue can be seen most clearly in California. In the first quarter, said the California Association of Realtors (CAR), the typical existing home cost $720,490. The price is so high that only 27% of all California households can afford it, down from 35% a year ago.
To buy that median-priced California home, CAR estimates that buyers need to make $131,200 and have 20% down (about $144,000 plus closing costs), enough to support a $3,280 monthly payment.
And sure, buyers can purchase with less money up-front, but that also means higher monthly mortgage payments, the need for mortgage insurance, and a larger qualifying income. High purchase costs are simply not an easy barrier to overcome. As Roseanne Roseannadanna (Gilda Radner) explained long ago, “it just goes to show you. It’s always something. If it’s not one thing, it’s another.”
Are inflation worries overstated?
“Inflation is often a self-fulfilling prophecy,” said Rick Sharga, Executive Vice President with RealtyTrac, a leading source of investor leads and data. “People think prices are rising too fast, so they buy lots of stuff now, forcing up prices. A string of higher prices then leads to — you guessed it — steeper inflation rates.”
But — maybe — inflation will be less of a worry than many expect and mortgage rates will continue to hover around 3% if not less.
One reason for inflation optimism is that we’re in uncharted economic territory. Dreary expectations may be wrong. We now have the combination of a recovering pandemic economy and a historic federal response. This is new stuff.
For instance, with so much financial turmoil, more bankruptcies seem likely. It hasn’t happened. Instead, according to the Administrative Office of the U.S. Courts, bankruptcies at the end of March were down 38.1% when compared with a year earlier.
And what about the states? You might expect their vaults to be empty, but that’s hardly the case.
“As it turns out,” reports The New York Times, “new data shows that a year after the pandemic wrought economic devastation around the country, forcing states to revise their revenue forecasts and prepare for the worst, for many the worst didn’t come.”
In fact, a number of state budgets are doing remarkably well.”
- Virginia is ahead by $500 million.
- Oregon expected a $2 billion shortfall but now looks forward to a surplus.
- Michigan is expecting a $4.7 billion surplus.
- California has such a huge surplus — more than $75 billion — that there’s even talk of taxpayer refunds!
“California’s coffers,” Politico reports, “are bulging thanks to the high-flying Silicon Valley, surging stock market and a large share of professionals who were able to continue working remotely during Covid-19. The state has a progressive income tax structure that leans heavily on top earners, allowing the state to enjoy record revenues despite widespread job losses in the travel and service industries that have kept California’s unemployment rate among the nation’s highest.”
Household income has hardly grown at all in recent years. That’s a problem if interest rates increase.
According to the Census Bureau, adjusted household income stood at $64,377 in 1999. By 2019 — 20 years later — adjusted household income reached only $68,703.
Meanwhile, in cash prices, the national median existing-home price was $136,700 in April 1999 according to NAR. By this April that same home was priced at $341,600. Just in the past year, existing home values increased 19.1%.
Wages haven’t kept up with home prices, but interest rates have fallen through the floor. Freddie Mac figures show that the mortgage financing available today at 2.95% was priced at 6.92% in April 1999.
It’s the bargain-basement mortgage rates that make homes affordable for many buyers.
Consider that typical $720,490 California home. With 20% down the amount financed is $576,392. At 2.95% over 30 years, the monthly payment for principal and interest is $2,415. At 6.92% the same financing has a monthly cost of $3,804. That’s a difference of $1,389 a month or $16,668 a year.
The Divided Market
In financial terms, it’s obvious that a lot of people have been terribly hurt during the pandemic. Just look at California’s bulging coffers, they illustrate the divide between those who have successfully navigated pandemic finances and those who have lost their jobs and fallen behind.
But bad times are not the whole story. A surprisingly-large number of people have survived the pandemic in good financial shape – again look at California’s looming surplus. Those who have been able to save and pay down debts are likely to be doing well. With cheap mortgage financing, they’re a big reason for bidding wars and higher home prices.
As to inflation, it can lead to higher mortgage rates but so far that hasn’t been the case. Instead, we have a marketplace with a lot of competition for homes, bidding wars in every state, low interest levels, and to this point a fierce appetite for real estate ownership.
The big surprise is that the housing sector and the economy in general are doing so well, something that was hardly a mortal lock just 12 months ago. Mortgage rates have remained low even with rising inflation levels, another surprise, and evidence that a lot of economists will have to re-think their models and assumptions.