Dec 05, 2016 | by Franck Cushner, CFP®
One of the common beliefs is that higher interest rates negatively impact the housing market. The thought is that if the cost of borrowing is higher, then there are less people willing to borrow and subsequently buy homes. While this works from the borrower point of view, the inverse is true for the lender. With low interest rates, lenders are not being fairly compensated for risk. As such, although we have had historically low rates, one of the reasons we have not seen a significant uptick in total mortgage debt outstanding is because banks are not lending to potential home-buyers. As with everything, it is supply and demand.
Adjusting for inflation, the Case-Shiller U.S. Home Price Index peaked around first quarter 2006. As the housing price index decreased until first quarter 2008, Americans continued to purchase homes (as seen in increasing total one- to four-family mortgage debt outstanding). Over this period, the Effective Fed Funds rate went from 4.6% to 2.6%, and the average 30 year fixed rate mortgage from 6.2% to 6.0%. This implies that throughout this period, lenders charged the same fee while overall market risk increased – implying they were either being overcompensated before or now accepting a lower level of compensation. For the next six years, the residential debt declined and housing prices bottomed out at the end of 2011. 2008 to 2014 saw the Fed Funds rate decline 96% (2.6% to 0.08%), mortgages 29% (6.0% to 4.3%), and total residential mortgage debt outstanding 21%. These numbers show that although there were significant decreases in rates, new mortgages were not occurring. To be clear, the market risk for lending was greater than the 4.3% mortgage rate that would be charged.
Perhaps discouraging, where positive correlation existed between home prices and mortgage debt from 1977 to 2012, this has not been the case since. While there has been a recovery in home prices, there has not been the same recovery in borrowing. Even though borrowers may be incentivized to take out mortgages – low rates and improving market – lenders still are unable to provide loans at recent rates of around 3.6%. But, interest rates are increasing (for the time being). One may now expect the housing market to improve (growth in mortgage debt), as higher interest rates indicate a stronger outlook on the economy, and less risk for the lenders. Rather, contrary to popular belief, for this time, raising interest rates could serve as a benefit for the housing market.
Overall, you will encounter many ‘truths’ about finance. The important thing is to understand the environment in which they worked and how it compares to now. As Heraclitus put so eloquently, "the only constant is change".
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