Mortgage rates have risen 1.10% since May and while 1% may not sound like much, it represents an increase of 67% and that does sound like a lot. Effectively rising interest rates means a home buyer can afford less and have to pay more for less, presuming that buyer is using conventional financing. It is widely presumed that an increase in borrowing costs means a decrease in home values since it costs more to finance, so the home therefore, should cost less to offset this rise in borrowing costs. This may be true at some point, but before home values can come down, they have to stop going up. Let me repeat, before prices can come down, they have to stop going up. This I predict, is where we are now.
It’ been widely reported that home values have been rising at the fastest clip since the boom year of 2006. According to the latest reading of S & P’s Case-Shiller, home values have recovered to roughly early 2004 price levels. With double digit year over year increases in every Metropolitan Statistical Area, the recovery is clearly broad based, and with the exception of San Francisco, the largest increases have taken place in the hardest hit areas. So clearly prices have risen sharply over the past 12 months. This increase will continue for a couple more months because the data Case-Shiller uses is based on closed transactions and there is an inherent lag since closed sales represent properties that have gone under contract as much as 60 or even 90 days ago. However, once we get a couple of months out from now, we should begin to see a slowing in the rate of home value appreciation and interest rates would be one of the principal reasons for this.
Another reason we should see a slowing in appreciation is that prices never go straight up, just as they never go straight down. Any month over month evaluation will show a jagged line, sometimes moving upward, sometimes downward and sometimes flat. This is just common sense and should be expected. During times of rising rates consumers who are affected by a change in borrowing costs have traditionally turned to variable rate loans as a way to improve affordability. Recently a client of mine asked me why anyone would take an adjustable rate. I explained that first, many people don’t anticipate staying in a home more than 5-7 years and in fact this is the national average. So by taking a shorter term a borrower receives a lower rate which offers lower payments but comes along with some greater risk. I told him that I have an adjustable hybrid loan that will adjust in a couple of years and that while it is concerning from a long term perspective, my history is that I refinance every handful of years and have never kept a mortgage longer than 5 years, ever.
There are analysts who suggest that this approach to borrowing is no longer a viable option and that the period of declining rates is over. Like the home value graph, interest rates never stay the same; never go straight up nor never go straight down. Naturally there will be a low at some point and perhaps we’ve experienced that. So to say we are no longer in a period of “declining rates” would not be inaccurate if we have really hit bottom. It is both accurate and inevitable. There has to be a bottom eventually and since we can’t decline from the bottom, rates have to go up some and even if they go up a little and then stay flat for a while, they’ve still stopped declining. To suggest however, that we are entering a period on intense interest rate increases like we had in the 1970’s and 1980’s, is to suggest that we are heading into a world of hyper-inflation, where the economy is so hot that to damper down the economic engine, the Federal Reserve would have to actually raise interest rates dramatically. Remember, thus far all the Fed has done is to suggest that if the economy continues to improve, they will begin slowing their aggressive stimulus (Quantitative Easing 3, QE3) of buying $85B worth mortgage backed securities per month. That’s correct, the Fed has not even begun slowing stimulus let alone actually raised interest rates. Moreover, I would argue in fact that the 1970’s and early 1980’s were the exception to interest rates trends rather than the rule. Remember how when rates were dropping we would hear things like, “We haven’t seen rates like this since the 1960’s?” That’s right, rates were low in the 1960’s. They were also low in the years preceding the 1960’s all the way back to WWII. So when you consider interest rate trends in terms of decades, I score that decades low 6 (1940’s, 50’s, 60‘s, 90’s, 00’s and 10’s), decades high 2 (1970’s and 80’s). I consider this decade on the low side because even if we were to rise significantly and double, we would still be well below double digits, plus we’re also 3.5 years into the 2010’s already.
Getting back to my point about the relationship of interest rates and home values, this rise in rates will likely have an effect in that it will slow appreciation and frankly, that is really welcome news. We don’t want to find ourselves in a bubble like 2004-07 and according to Case-Shiller, we are only at the beginnings price levels of that bubble. So yes, the rise in rates makes homes more expensive, but if slowing appreciation is the byproduct, then I say “Bully!” We can’t have homes go straight up without having our incomes increasing too and in this day and age of the global economy, as much as I’d like to say rising incomes are imminent, I suspect not so much.