All Things Come to an End (Including Historically Low Interest Rates)

All things come to an end (Chaucer) and so it goes for the historically low mortgage interest rates that we have seen over the preceding eighteen months. The yield on ten year U.S. Treasury bonds has been rising since QE2 began about seven weeks ago. But it’s not just U.S. bonds; European (even German – generally considered the safest), Japanese, and U.K. bonds are moving up as well. To understand why this is significant to us, you need to know that home loan rates are tied to mortgage backed securities which are essentially a type of bond. The equities markets are also rallying (stocks rose to their highest level in two years today). As yields in the sovereign debt market rise (generally considered the lowest risk investments), and the equity markets produce increasing profits for shareholders, investors will insist upon an even higher rate of return in the mortgage backed securities market. Additionally, the recent tax cuts in the U.S., which are in effect another stimulus plan, make investors increasingly wary of holding long-term debt (like mortgages) at low, fixed rates of return. And thus, home interest rates at the consumer level rise in order to offer investors the increased return they demand. Over time, it is likely that home loan rates will continue to rise. The Fed has suggested that all further stimulus options remain on the table should the economy require it. Existing and future stimulus will result in inflation, as already evidenced by last week’s Producer Price Index and Consumer Price Index. Inflation erodes the value of the fixed rate of return offered by bonds. Anticipation of future inflation will be built in to current bond prices, thus driving up mortgage interest rates even before the inflation occurs. However, current interest rates are still at historic lows (see graph at this link: http://is.gd/jbfGB). As interest rates rise, there will be downward pressure on home prices. This is because consumer capacity to pay increased monthly debt service will not rise along with interest rates. Let’s look at an example of how this plays out: • The monthly payment on a loan of $1mil on a 30 year fixed rate note with an APR of 5% is $5,368. If the APR increases to 6%, the monthly payment for the exact same loan increases to $5,995 (a $637 per month increase). If the APR increases to 7% (i.e. 2002 levels), the monthly payment increases to $6,653 (a $1,285 per month increase). The consumer has three options; 1) make a larger down payment so that they can borrow less and keep their monthly payment the same; or 2) pay more per month on their mortgage payment; or 3) purchase a less expensive property so that they can maintain their down payment amount and monthly debt service. Most purchasers will be unable to do 1) or 2) and reluctant to do 3). This could result in decreased velocity in the markets as potential buyers postpone purchasing decisions. Sellers who need to sell will likely respond with another round of price decreases to encourage buyers into option 3). Of course, the purchaser’s monthly payment will be unlikely to decrease below today’s levels – they will buy the same property at a lower basis but with a loan at a higher rate of interest. The seller will likely suffer the greatest loss in the form of decreasing sales price spawned by the increased cost of capital in the marketplace. So where does that leave us today? Now may be an ideal time to lock in historically low prices that can be fixed for the next thirty years or as long as you keep your property. Sellers may wish to take advantage of this sentiment among purchasers by listing their property after the New Year rather than hoping for the capital markets to reverse course, which may turn out to be a risky bet.