After softening for much of 2018, the housing market remains stable after a boost from lower mortgage rates and slowing home price growth.
TOP STORY: Understanding Mortgage Interest Rates
It has been years since it seemed necessary to think much about interest rates. There has been the once-a-month ritual of watching and worrying over Federal Reserve decision making, but beyond that, very little drama. As everyone’s mother has probably said, eventually you can get used to anything and Americans have definitely gotten accustomed to rock bottom interest rates. Is it time to get used to a different reality? Maybe. But it wouldn’t be the first time.
A Little History
Freddie Mac is the go-to for interest rate information; its Primary Mortgage Rate Index has been around since April 1971. Over that near half century, the 30-yearfixed-rate mortgage (FRM) averaged 8.35%, but that is only half the story. Rates climbed into double digits in late 1978 and remained there for nine years. In fact, they peaked at 18.63% in the fall of 1981. Rates started to slide to historic lows coincident with the turn of this century and dropped below 4.0% for the first time ever in October 2011. From 1971 to the end of 1999, rates averaged 9.57%. Over the 17 years since, the average has been 5.03%.
In the 1970s people were accustomed to rates in the 8-9% range, and in the next decade they got used to 15% or higher. And they still bought houses, even when rates soared to over 18%. This ancient history doesn’t suggest any immediate need to adapt to rates like those in the 1980s, or even the 1990s.
Most economists predict that near-term increases will be gradual, remaining in the 4-5% range this year and maybe even into 2020. How do they know? They don’t for sure, but forecasting isn’t magic; it’s math and the experts have some established rules to follow.
Why Rates Change
Money is a commodity, subject to supply and demand like gold or toothpaste. There is a finite supply of gold; it is beautiful, has many uses, and mining it is difficult and expensive, so we put a high value on it. If the world were running out of toothpaste however, Proctor and Gamble would just make more of it.
You can buy or sell money just as you can any commodity, there just isn’t much point to doing so because the price of a dollar is always a dollar. Its value, that is, what it can buy, does change based on supply and demand. When wages go up, there is more money in the system, and prices – that is the rate of inflation – also rise, although not necessarily at the same pace.
We don’t buy and sell money, but we do invest and borrow it and interest is the price for using someone else’s money. Those that have the money can set the price for borrowing it, but only to the level that borrowers are willing to pay. Like gold or toothpaste, interest rates are subject to the laws of supply and demand and those laws are very rational. View Current Interest Rates.
Investors have a wide choice of places to put their money, and naturally they want to invest it where they can get the highest return. But that desire is tempered by other considerations, most particularly an aversion to risk. They want assurances they are going to get their money back and that, when they do, it is in approximately the same condition they expected it would be. That is, that their dollars have not lost so much value it has wiped out their rate of return. While investors are wary of payback risk, they realize that time and inflation are risks to their return as well.
Whether they are investing $100 or $100,000,000, the most risk averse investors only want the safest of investments, for example Treasury notes or FDIC insured savings accounts, both backed by the full faith and credit of the U.S. government. Buying a Megabucks ticket or a penny stock are at the other end of the spectrum; incredibly high odds of ever seeing the penny or the dollar again.
But a typical online savings account currently pays around 2.0% each year in interest while the payback on that lottery ticket, while highly unlikely, could be thousands or even millions of times greater than the investment. If you have $100, risking an occasional $1 of it might not be a totally irrational decision.
By the same token, even the most cautious investor, might willingly forgo a 100% guaranty of safety to achieve a higher rate of return. The trick on both the investor and the borrower side is figuring the price that makes sense when offering or accepting a 5% or a 20% level of risk.
How well the market prices risk goes a long way toward determining the supply of money that will be available for investing as well as the demand for borrowing it. It is also important to remember that, while some borrowers will have a critical need for funds, many investors have an equally critical need to lend it. A huge industry exists solely to manage investments, and money that is sitting idle isn’t producing a return. The point is, neither borrower nor investor is in control of the markets or setting a price for risk.
The measuring stick for the lowest interest rates is the price of U.S. Treasuries. In buying them, an investor is loaning money to the government, and the rate attached to them is referred to as the yield. Since the government has never defaulted on its debt, the investor has a nearly 100% guarantee of getting his or her money back.
An investor in Treasuries can choose for how long they would like to lend to the government. If short term, they can buy Treasury bills, with various payback periods of one month to one year. Treasury notes have terms of two, five, and ten years, and the “long bond” is not repaid for 30 years. The ten- year note is the most popular instrument for investors.
Because of the time value of money, the different terms of Treasuries affect their yields. For example, at this writing, the 1-month bill has a yield of 2.341%, the 10-year pays 2.70% and the 30-year is priced at 3.03%. The difference reflects the greater risk that the value of the investment will diminish as inflation increases overtime. The higher yield for the longer terms also reflects opportunity costs, the chance that the investor will have to forego other, perhaps more lucrative investments while his or her cash is tied up in that instrument.
Riskier possibilities must compete with Treasuries for the same investors, so their rates of return reflect treasury yields. The competition includes money markets, corporate bonds, and home mortgages, the latter of which are used as collateral for bond-type instruments called mortgage backed securities (MBS). Consequently, the interest rate on a 30-year fixed-rate mortgage (FRM) will track the yield on the long bond, and the 15-year FRM will be in sync with the 10-year note. The mortgage rates will be higher, because of risk, but they will move up or down together.
BARGAIN OR BOO-BOO?
A pre-purchase appraisal has one of three results; it matches the purchase price or comes in higher or lower. When it differs, borrowers wonder whether they overpaid, or got a bargain.
An analysis of homes bought in California after 2010 and resold after more than 18 months, found those with high appraisals appreciated faster than the local market, an average of 3.3%. Those with close matches appreciated in line with other homes, while those with lower appraisals fell a little short. Not badly however, only 0.3%.
The bottom line? Be happy if you got a bargain, don’t worry if you didn’t, and appraisers seem to really know their stuff. CoreLogic Insights
Going, Going, Sold
Treasuries are sold at auctions. The government decides how much they need to borrow, while investors decide how much they are willing to pay, perhaps for a bill that will return $10,000 after six months. If an investor offers to pay $9,800 for that bill, his or her yield will be 4.01%. As the purchase price moves higher, the yield moves lower.
The yields produced at auctions tells us a lot about the economy; things such as supply and demand, inflation, and investors’ appetite for risk. For example, when the stock market is doing well or demand for other investments rises along with their price, Treasury auctions may not go well. Investors move their money to other places that will provide a greater return. On the other hand, when there is global unrest, the stock market corrects, or when there are other uncertainties, there is what economists call a “flight to safety;” money flees into the bond market, and yields drop. Mortgage rates will almost immediately follow either type of adjustment.
“The softening home price appreciation in the latest Case-Shiller index will continue in the upcoming months as housing inventory builds. But it is unlikely for the national median home price to actually decline given the housing shortage of moderately priced homes and from job additions in the economy;
In 2019, home prices in many markets look to trail income growth for the first time since 2012. That is a healthy development of keeping housing affordability in check.” Lawrence Yun, NAR Chief Economist
One such market mover was the Thursday, June 23, 2016 election in which the United Kingdom voted to leave the European Union. The initiative wasn’t expected to pass, and that day the Dow Jones Index closed at 18,011, 30-year Treasuries had a 2.55% yield and Freddie Mac’s average 30-year FRM rate was 3.56%. By Monday when the news had time to settle in, the Dow Jones had dropped about 900 points. The Treasury yield went down by .27 percentage points (and dropped another 14 basis points over the next few days) as stock market money flooded into Treasuries and their relatively low-risk competition. The flight to safety was reflected in mortgage rates; Freddie Mac’s 30-year FRM went down 15 basis points.
SWINGING TOO FAR
“Homeownership is a valuable institution, allowing families to build wealth and serving as a measure of financial security, but recently the focus has shifted toward other aspects of upward mobility.
Government policies in the 1990s and early 2000s may have put too much emphasis on the benefits of home- ownership (versus renting) but the pendul um seems to have swung too far the other way, and many now may have too little faith in home- ownership as part of the American Dream.” Laurie Goodman, Christopher Mayer, Journal of Economic Perspectives
What About the Fed?
There is one other factor that should be mentioned in a discussion of rates and yields, demand and risk. The Federal Reserve and its monetary policy usually plays around the edges of rates, but sometimes the Fed will find it necessary to jump all-in. It did so both in the days of 18% rates and during our recent prolonged period of super low ones.
In the earlier case, the country had been dealing with some crazy inflation. The Consumer Price Index exceeded 7% in mid-year 1981, so the Fed raised rates to limit borrowing and drain some of the enthusiasm out of the system. It did the opposite following the financial crisis of 2008. Inflation fell, dropping into negative numbers, banks tightened credit, and the economy was stalling. The Fed took two actions, dropping its funds rate – the interest charged by banks to lend to each other – to zero, and buying Treasuries and MBS in huge numbers to keep money flowing into the system, long term rates low, and stimulate business activity.
Only after job growth became strong and inflation got back to more normal levels did the Fed withdraw to the sidelines. Raising the funds rate, which at this writing is at 2.5%, was immediately reflected in higher short-term rates but had no effect on long term rates like mortgages. Once the Fed stopped purchasing Treasury notes and bonds, lessening the competition to buy them, rates for Treasuries, and consequently fixed rate mortgages, once again began to rise.
A Little Test…
While economists continue to ponder the velocity and direction of rate changes, why not try to do a little forecasting of your own? Keep one eye on inflation, and the other on how Treasuries respond. You might enjoy the exercise.