Mortgage rates have been at or near record low levels for quite some time. Much of this is a byproduct of low rates from the Federal Reserve to the banks, which are able to pass along the low cost of borrowing to their customers.
The hope is that the low rates will encourage more home purchases, allowing for a recovery in the housing market.
The results have been mixed, at least if you look at the news. Though rates have been low for a few years now, only within the past few months have I seen a lot of news articles proclaiming that there actually is a recovery in the housing market.
I believe that these rates will help the market, but more in a long term way. This is unusual as most policy these days is only focused on the short term effects. After all, if the United States government has been kicking the Medicare and Social Security cans down the road for decades now, it pretty much shows that nothing long term is ever in the forefront of anybody’s mind.
Here is how I think the low rates will have a long term effect on housing.
Low Rates (And Prices) Encourage Shorter Term Loans
In the past, it seemed everybody got a 30-year mortgage. This meant that you spent thirty years paying back the loan. With higher rates as well as higher home prices, the fact was that the only way many people could afford the monthly payments on a home was to take a 30-year loan.
Now, lower prices combined with lower rates give for more flexibility. Let’s look at a couple of examples on a Make Believe house.
In 2007, this house might have cost $250,000. Say you financed all of it (a likely scenario back then), and your rate was 6%. Your total mortgage payment (principle and interest) would have been $1,498.88.
Fast forward five years. That home has likely fallen in value. You could probably get it for $200,000. On top of that, rates have fallen so much that you could finance that home for 3% if you were to a 15-year note.
If you financed all of that home today with the 15-year mortgage, your principle and interest payment would total $1,381.16.
That means the same home could be paid off in half the time for over $100 less per month.
The Payment Will Come Out Cheaper
On top of that, one of the assumptions I made in my above scenario is likely false. That being, you would probably not be allowed to finance 100% of the mortgage in today’s lending restrictions. While that might lock some people out of the market, those who have, say, 10% saved would only need to finance $180,000.
This would take their payment down to $1,243.05 per month, an even greater reduction in your monthly outlay.
How This Saves The Market
While this is all great information and reduces the cost of home ownership (at least from a cash flow perspective), I can see some people scratching their heads on how this will help the market.
The answer is simple.
The lower rates and the forced down payments will build equity in homes at a much more rapid rate than ever before.
Let’s go back to the 2007 scenario above. Considering my example, I effectively said that the housing crash took 20% of the equity from that house. In order for that homeowner to have remained above water, they would have had to stay above the $200,000 principle balance. With the factors I outlined above (zero down, 30-year, 6%), it would have taken eleven years and eight months before they would have paid off that 20% in equity. That’s almost 40% of the term of the mortgage to get to that 20% level. That is a long time!
Fast forwarding to the other scenario I gave with the $200,000 purchase price and 3% rates on a 15-year mortgage, the homeowner would have to have their balance at or below $160,000 to stay ‘protected’ from going underwater.
For the sake of argument, let’s say the homeowner was able to finance 100%. Even with that, it would only take three years and eight months to reach the 20% equity stake in their house ($160,000). That’s a significant difference. That is an entire eight years sooner to build that equity stake.
It Only Gets Better
But, let’s not forget that the banks, these days, are likely going to require you to put 10% down. So, that homeowner who puts 10% down, finances the rest at a 15-year 3% rate, is going to find their 20% equity stake arrives at just two years and one month. That’s nine and a half years sooner than they would have gotten in 2007.
What Does This Mean?
I believe that this benefits homeowners and the housing market in the long term because equity will be built at a much more rapid rate than ever before. This protects homeowners in the event of a downturn.
When the market took a 20% downturn a few years ago, most homeowners who had bought in the last few years were instantly wiped out. If it takes eleven years to get to 20%, think about how little equity there was for someone who had just moved in. This instantly created devastation in the market.
Imagine if another downturn took place in the next five years. Guess what will happen? Well, to anybody who bought their home, put 10% down and financed to a 15-year 3% mortgage, the answer is: Not much. Because they would still have positive equity in their home.
This would mean less people would walk away. Less foreclosures. Less short sales. Less banks taking over street after street. Less disrepair taking over neighborhoods.
And It Only Gets Better
It’s sort of a positive catch-22, because more equity would protect us in the event of a housing crash, but I believe the equity will also prevent a future housing crash. So, what will happen is prices will actually start rising again. And, what will happen after that is that people who are sitting on the sidelines will suddenly realize that the real estate market is on solid ground and will get back in the game. This will push prices up further. If rates stay low, this will mean more equity will be created in the housing market, providing it additional stability for years to come.
The housing market got very leveraged and this caused an artificial rise in prices, which led to the crash. I believe now that the market is getting deleveraged, this will also create a rise in prices. The difference being, the rise will be one built on solid ground.
I’d love to hear your thoughts.