I was reading a fantastic article over at Dr. Housing Bubble Blog about how now isn’t the time to buy a house in Southern California. I won’t argue one bit with Dr. Housing’s analysis, because I agree with it entirely. No sane person would be looking to buy a place in southern California, and definitely not within any of the neighborhoods Dr. Housing has honored as a “Real Home of Genius” neighborhood. These ‘featured’ neighborhoods are a great synopsis of neighborhoods where a person can ‘invest’ and lose a lot of money. His main thesis is that there are multiple signs that should warn anyone about when is and isn’t a great time to buy real estate. One of the more interesting graphs he shows is from the US Gov. and details the average mortgage rate in America. The graph is shown below:
Source: Article by Dr. Housing Bubble Blog.
One of the real reasons that this graph is so valuable is due to how people in America buy Real Estate. They buy a fixed monthly payment that lasts for 30 years. This allows them to amortize the cost of the house over an extended period, while paying an interest rate commensurate with long term inflation risk. Many people think that they’re getting a good deal, because the payment stays fixed and inflation helps to ease the burden in the future. What they don’t realize is that the bank’s mortgage rate more than compensates for inflation and still charges a premium for the money loaned. (Ex. current conforming mortgage rates are around 4.35%, 10 yr T-bond is at 2.75%, and the current annualized inflation rate for the US is around 1%. There are decent margin spreads on the mortgage rate over both comparable indices.)
More importantly, when people buy a house they have two things they have to qualify for to actually buy the place. They have to have an adequate down payment (which is usually 20%), and they have to afford the monthly payment on the note. Each and every month for 360 payments they have to come up with the amount that they’ve signed up for. This is no mean feat and figures hugely in the affordability of the house. Typically, the home buyer allows the bank to do this calculation for them and present them with the amount that they can afford. What most people don’t realize is that the interest payment for a mortgage note is a huge factor in how much house you can afford. The amount of the note moves inversely with the interest rate. Consider a typical house with a price of $250,000, a down payment of $50,000 (20%), and at the long term average of 9% in interest rate. The average monthly payment is $1,500. This is a reasonable amount per month. What would that monthly payment be if the interest rate was say 7%, or 5%? At 7% it would be only $1,166.67 a month and at 5% it would be $833.33. At a 5% interest rate you can nearly afford a house that is twice the principal (or $500,000). Does this mean that you can buy a house twice the size? Not really. In the real world, the typical price for a house rises and the monthly payment stays the same. The main reason for this is that as interest rates go down, people realize they can afford more (per month) and they then tend to bid more per house which raises the overall price of housing.
As long as interest rates fall and price goes up as a result, it’s a virtuous circle because people gain equity due to their initial leverage when they purchase. When interest rates rise and price goes down as a result, it can easily wipe out home buyers equity and help speed along the possibility of default. I built a quick and dirty table in excel to help visualize the reduction in home prices IF a mean reversion in interest rates occur. I fully expect some sort of mean reversion within the next five years and this table helps determine how much I can lose when purchasing real estate. In the table I’ve listed three interest rates- 4.35%, 6%, and 9% and a home price of $600,000.00, with 20% down. These interest rates represent the current mortgage environment, a rate we’ve seen just within the last five years, and the typical average. The calculation is shown below:
The calculation lists the effective home price for a house with a similar monthly payment (called ‘monthly nut’ in the spreadsheet). Using this spreadsheet calculation, I can see that a house currently worth $600k currently is only really worth $290k if interest rates move. This represents over a 50% loss if one was to purchase a house at the current prevailing interest rates. That is something to seriously consider if you’re planning on buying.
Note: The reason the monthly nut isn’t the same in all three lines is because the imputed down payment in the following rows is held constant. If one was to reduce the down payment to 20% of the effective house price we would have a table that looks like this:
Another couple of points: The rate listed is the annual percentage rate (or APR), the term is the number of months of the loan (so 30 years at 12 months per year is equal to 360 total months), the effective rate is the monthly interest rate (i.e. for the 4.35%/year rate it is just 4.35%/12 months or 0.36%/month) the cashflow is the monthly expenditure required for the loan (both principal and interest amounts) PER EVERY 1oo THOUSAND DOLLARS (which is the present value column). The house price is the full purchase price that the house would retail for if the monthly payments (aka monthly nut) stayed constant, and finally the down payment is the amount put down for the loan.
Update: Since I actually put this article together (two weeks ago), interest rates have turned in the market and a slew of articles by other bloggers have appeared also detailing the same issue I bring up. Namely, as interest rates turn, house prices will fall.
Mortgage interest rates hit five-month high by IrvineRenter on Irvine Housing Blog and
Mortgage Rates Go Parabolic by Tyler Durden on ZeroHedge
If mortgage rates keep increasing, you will probably see a decent uptick in articles about the drop in house prices because of it and widespread pressure on house prices in 2011.