Will rising mortgage rates delay housing recovery?

December 08th, 2010

2010 has not seen any significant rebound in the housing markets nationwide. Foreclosures are still prevalent throughout the country, creating over-supply and dampening prices. Many potential buyers are using mortgage calculators to be ready for when they feel the housing market bottoms out on prices. If you are waiting, is it wise to wait? Are lower prices still to come? Or will your prequalification calculator show that due to rising interest rates the home you could buy in the future is no better than the one you could buy today?

Mortgage rates rise, housing prices fall

The most obvious impact higher rates can have on housing prices is that higher mortgage rates reduce the amount of the mortgage for which you can qualify. If your qualifying mortgage payment is $1,250 per month, that translates to about $260,000 at 4.00 percent for a 30-year mortgage. That same payment and term will support a $245,000 mortgage at 4.50 percent, a reduction of about 6 percent in purchasing power.

If borrowers qualify for lower loan amounts demand is reduced; lower demand with constant supply results in lower prices. Absent some other factor, such as increasing employment which could bring more buyers to market, all other things being equal, higher mortgage rates tend to depress housing prices.

Up in ARMs

Another factor that impacts housing prices in the current housing market cycle as a result of higher interest rates are the Adjustable Rate Mortgages (ARMs) funded through the housing bubble from 2001 well into 2007. Those homeowners who are in ARMs have seen their payments drop consistently from when they funded into November as the indices upon which they are based (typically the 1-year Treasury bill or the London Interbank Offering Rate or LIBOR) have fallen to below 2 percent.

As rates begin to rise, so too will ARM mortgage payments. Depending on how fast the rates rise some homeowners may find the resulting increase in payments too burdensome, causing defaults to rise.

While ARMs have payment and interest rate caps that prevent large jumps in monthly payments when the rates do adjust, adjust they must and sooner rather than later those adjustments will be for higher rates and payments. Many in the housing industry are concerned that rising interest rates will force more homeowners into default and foreclosure. Should this occur, the resulting increase in foreclosures through ARM adjustments will add more supply to housing markets.

To buy or to wait?

If your gut tells you rates are going to increase and home values are going to decrease in 2011 is it better for you to wait until prices reach the bottom or buy now before rates increase? Before answering this question you need to decide if you can accept the possibility that if you do purchase now your home value may go down.

If you are purchasing for the long term and feel home values will rebound at some point in the future you may not mind a decrease in value for a few years. However if this does concern you then you will be willing to wait until what you feel is the bottom of the price market and take your chances on what mortgage rates will then be available.

Compare two scenarios

Use the mortgage calculators to help you with this decision to buy or to wait. As we saw with the example above, if you qualify for a monthly mortgage payment of $1,250, a rate increase from 4.00 percent to 4.50 percent decreases your qualifying loan by about $15,000. If you are putting 10 percent down your purchase price has declined from around $290,000 to near $270,000. What if home prices drop ten percent and the home you are looking at today for $290,000 is later available for $260,000? And what if at the same time interest rates have risen from 4.50 percent to 5.50 percent?

Case 1:

Price = $290,000

10 percent down payment = $29,000

Mortgage = $261,000

Monthly principal and interest at 4.50 percent = $1,322

Case 2:

Price drops ten percent and mortgage rate increases one percent:

Price = $261,000

10% down payment = $26,100

Mortgage = $234,900

Monthly principal and interest at 5.50 percent = $1,334

In this case the lower price and higher interest rate home is virtually the same payment as the higher price and lower interest rate home. if you are confident that the drop in home price will balance the increase in rate, it's in your best interest to wait because your loan will be smaller. Run your own scenarios on the mortgage calculators to determine when it might make sense to purchase if you feel prices may go lower while mortgage rates rise. You may find that a higher mortgage rate increase along with a smaller drop in price, say 5 percent, suggests that you may want to purchase sooner, with a slightly higher price but lower mortgage rate available today.

Posted By :
Dennis C. Smith is co-owner and broker of record for Stratis Financial in southern California. He has over twenty years' experience in the mortgage industry.

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