Dec. 28, 2016
Buyers this past summer got a great deal on their loans, with interest rates at around 3.5%. Since then, rates have shot up from 3.5% to 4.5%. How are interest rates priced anyway? And what do rising interest rates mean for the housing market and the economy overall? Should anyone still consider buying a home right now?
Pricing interest rates
Let's start with the first question: how are interest rates priced? Economics writer Paul Solman offers some insight:
Think of a market interest rate as the sum of three separate factors: waiting, repayment risk, and inflation.
1. First, waiting — also known as the time value of money. Imagine an inflation-free environment, such as today’s. Which would you take: a thousand dollars today or a thousand dollars, guaranteed, a year from now? Unless you’re a very unusual person, it’s the thousand right now, so you can do something with the money. If you forgo the money, you generally need to be paid something for doing so, for waiting — in recent history, around 2 percent a year.
2. Second is the risk of not being paid back. This is why folks with low FICO scores have to pay such high rates of interest. This obviously varies enormously. But the U.S. government has generally been thought to pay the “risk-free” rate: 0 percent for risk.
3. The rest of the interest rate is inflation. If money is losing value and you lend it, you’re going to expect to be reimbursed for the loss.
So what do rising interest rates mean?
When interest rates are lower, more buyers are able to borrow money. When more money is being borrowed, more money is being spent (After all, people don't take out loans to add to their savings). This increase in purchasing pumps money into the national economy. Then when consumers have been steadily fueling the economy for a while, the Fed will typically respond by raising rates. When rates are higher, purchasing slows. And when purchasing slows, so does inflation.
Therefore, interest rates rise as a result of inflation. Steady inflation is natural. It is indicative of a healthy economy. On the other hand, no inflation or deflation (the lowering of prices) is related to economic recession and depression. And so rising interest rates are a sign that our economy has been doing well.
What does this mean for home owners?
Inflation means your home is increasing in value, which is good. Now, with a higher home value, property taxes will be higher, but only because the home owner's net worth has gone up. The beautiful thing about a mortgage payment is that it stays the same for 30 years. Rents may go up, interest rates may go up, but your mortgage payment stays the same.
What does this mean for renters?
Obviously, rent goes up. Healthy inflation results in higher wages, but it also results in higher everything, rent included.
What do higher rates mean for would-be borrowers?
The most obvious answer is higher monthly payments (If, of course, you don't already have a mortgage. If you already have a mortgage, higher rates have no impact on your monthly payment). The difference between 3.5% and 4.5% on a $500,000 mortgage is $288 more per month, which comes out to $3,456 more per year. Today's borrower will pay that much more on interest than her friend who borrowed the same amount of money in June.
Since higher rates result in higher payments, the buyer pool shrinks. Here are some effects:
1. A few would-be buyers will no longer qualify for loans and therefore will not be able to buy.
2. Some buyers will get approved for less than what they would've got when interest rates were lower and will choose not to buy.
3. Many buyers who get approved for less will borrow what they can and buy at that price point.
4. Stronger buyers (all cash or high earners with high credit scores) will continue to buy what they want.
Why even buy right now?
Why would anyone choose to buy when rates are the highest they've been in 2 years? Here are some reasons, below:
1. It could be worse ... in fact it has been in the past. If you've just started looking for a home this year, you may have grown accustomed to seeing interest rates between 3.5%-4.0%. Believe it or not, rates right now (at 4.5%) are still low. The average interest rate over the last 30 years is 7%, as shown in the graph above. In the late 80's, interest rates were at 10%. In 1981 (not shown on graph) the average rate was 17%! If interest rates go up next year, you may wish you'd borrowed at 4.5%.
2. It could get better. If rates go back down after you purchase, you may choose to refinance to a lower rate.
3. You still need somewhere to live. Higher interest rates don't take away the reason you were looking for a home in the first place.
You are not alone
If you buy in 2017, will you be among the many or among the few? Interestingly enough, the Mortgage Bankers Association predicts an 11% increase in new home mortgages next year, in spite of projected increases in mortgage interest rates.
TransUnion, a credit analytics company, attributes the increase to lower unemployment rates and higher household incomes. These factors should allow more first-time buyers into the game. "We believe with improved economic conditions we could see nearly 3 million first-time homebuyers in 2017," said Joe Mellman, TransUnion VP.
You would have a home
Why buy? You would have a home. I bought my first condo in Honolulu in September and was able to have my parents over for Christmas this year. My dad complimented the job I did putting in new flooring. Mom kicked back on my leather couch and watched White Christmas while my sister and I made omelettes and cocoa mochi in the kitchen. Grandma had one long nap, interrupted only by brunch and the obligatory photo op. I told a friend about it later and he said, "That's the dream isn't it? to have your parents over at your place for Christmas."
"Yeah man," I told him, "It was a dream come true." And you can't put a price on that.