The double-edged sword of low mortgage rates

By Felix Salmon
June 28, 2010
10-year Treasury yields are now a hair's breadth away from breaking the 3% barrier. And where long-term interest rates go, mortgage rates are bound to follow. So it's easy to see why the purple line is falling on this chart, which comes from Barry Ritholtz and which is doing the rounds today:

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Long-term interest rates are tumbling further today: 10-year Treasury yields are now a hair’s breadth away from breaking the 3% barrier. And where long-term interest rates go, mortgage rates are bound to follow. So it’s easy to see why the purple line is falling on this chart, which comes from Barry Ritholtz and which is doing the rounds today:

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Meanwhile, it’s equally easy to see why the red line is rising. It’s the ratio of rents to prices, and the first-order effect of falling prices is rising rent-to-price ratios.

But Paul Kasriel of Northern Trust reads a lot into this chart: it’s cheaper to buy than to rent, and therefore now is a good time to buy. Indeed, he says, “housing is about as an attractive a purchase as it has been in the past 40 years.”

Certainly housing is more attractive now than it was, say, five years ago: both prices and mortgage rates are significantly lower than they were back then. But back then we were near the top of the biggest housing bubble this country has ever seen, and finding house prices now attractive in relation to house prices then is akin to getting excited by Yahoo stock now, on the grounds that it costs so much less than it did in 2000.

The big picture, in terms of house prices and interest rates, is clear: prices go up when rates are falling, and they go down when rates are rising. That stands to reason: people buy what they can afford. When you’re selling your house you care about the headline price, but when you’re buying it you mostly care about how much money you’re going to have to spend each month in mortgage, taxes, and maintenance. If mortgage rates go up, the amount of mortgage you can get for any given monthly payment goes down, and so house prices have to come down lest they become out of reach.

In a housing bubble, this arithmetic is temporarily sidelined, as people buy houses they can’t afford. So where will prices from here, given that mortgage rates can only go up rather than down? Essentially, there are only two choices. Either buyers remain rational and only buy what they can afford, in which case prices are bound to fall sooner or later, when interest rates rise. Or else buyers stop being rational, start buying houses they can’t afford, and we have another bubble.

As for rents, they tend to lag prices: they never rose as much as prices did during the bubble, and they haven’t fallen as much as prices have during the bust. But as homeownership rates fall and America’s stock of foreclosed houses starts being rented out, the natural pressure on rents is likely to be down rather than up. Plug negative annual rent increases into the NYT’s buy vs rent calculator, and it’s really hard to make the case that buying is better than renting over any timeframe.

More generally, I simply don’t believe any chart which seems to imply that you can buy a house and rent it out for literally double what you’re paying on your mortgage. That might conceivably be possible in a few of the areas hardest hit by the housing bust, and I’ll happily advise anybody who finds such a market to go ahead and buy right now. A lot of the time, of course, it’s very hard to tell: American neighborhoods often have very few renters, and there’s really no such thing as the market rent in such places. There can also be serious local-market disconnects: it’s not uncommon to find would-be renters saying that there’s nothing available at any price, even as would-be landlords say that they can’t find a renter at any price.

If I could ask Kasriel one question, it would be this: when was the last time that historically low mortgage rates signalled a good time to buy, in any country? In pretty much every such case, I think, prices have only gone up if rates have fallen lower still. But now we’re bumping along the zero lower bound, and the only way that mortgage rates are falling significantly from these levels is if we get another monster recession. Which certainly won’t help house prices.

Comments
18 comments so far

2 Questions/Comments:

1 – Based on your logic above, doesn’t it still make sense for a long-term (planning on staying in their home for 15+ years) buyer to buy now? They will benefit from those low monthly expenses and not really care if housing prices fall. Wouldn’t waiting just raise their monthly cost of living in the same home?

2 – I’m not sure I get the rents will go down because home ownership will go down argument. Where are all the people from the foreclosed home going? Won’t they be renting, increasing demand for rentals, just as the homes add to supply? And aren’t they more likely to relocate and rent in current rental heavy markets, not the economically depressed neighborhoods they’ve left that “often have very few rentals”? I can easily imagine a net rise in rental costs.

Posted by Dan_K | Report as abusive

When rates rise home prices will drop such that the monthly expense of buying a property remains within the range of what buyers can afford based on their income. The affordability constraint on home prices would still hold in a higher interest rate environment. On the second question it seems that during the bubble the construction industry built a large surplus inventory of residential units for sale, which will become a surplus of rental units — particularly since renters tend to have roommates and other higher density occupancy arrangements than buyers and owners tend to have.

Posted by J-Cerr | Report as abusive

Good points Dan K.

It may not be the best time for first time homeowners to buy, but only because they might not understand the nuances of the real estate market or the risks and might be duped by an agent or brokers trying to make a sale in an inflated market to get a higher commission.

If you know the market and know a good deal, it doesn’t matter if the interest rates are low. Lock it in. What matters if you are happier owning a home and paying your 1k a month to be stable and serene and independent or rent and be at the whim of the landlord.

After 15 years, as stated above, a wise homeowner should be well on their way to owning the home outright, and thus paying more and more on the house as long as they take a conventional mortgage in the first place.

(And if bad times come, you can always rent the extra bedrooms)

Posted by hsvkitty | Report as abusive

I believe if you buy a house in June 2010 in most places in America, it is almost certain you won’t see major depreciation in nominal terms.

Why? Because if Bernanke has learned anything at all in this ordeal, it is to stop falling house prices. Quantitative easing is a giant bazooka with unlimited ammunition. Nominal asset prices do not have to fall if a central bank is determined, as Bernanke showed us last year.

On the other hand, the upside of housing may be limited too. If house prices are stable or go upward, the Fed does not print and may even sell some ABSs on its books.

Pimco has long advocated that the Fed base the inflation input of its policy on asset prices on not merely on CPI. Ben Bernanke surely knows to do that now.

Posted by DanHess | Report as abusive

A chart like this would be very valuable when looking at the market in that regard. Clicking on advanced setting to get more costs and amortization. (sorry if you added this at another time..I never saw it if you did)

http://www.nytimes.com/interactive/busin ess/buy-rent-calculator.html?ref=patrick .net

Posted by hsvkitty | Report as abusive

hsvkitty, it was (and is) the last link in the blog

Posted by FelixSalmon | Report as abusive

I love Kasriel most of the time, but here, I’m with this: “don’t believe any chart which seems to imply that you can buy a house and rent it out for literally double.. your mortgage.” If you could, everyone with a spare penny of borrowing capacity would be doing it. That they’re not tells you that the imputed-rent series is bad.

In my neighborhood, by way of comparison, cap rates at list are under 5% for junky multiunit places, under 4% for tatty condos, and barely scraping 3% for single-family detacheds in good locations. Yet Kasriel’s chart has cap rates at 7.5%. You can get a 7.5% cap rate, true, if you are willing to be a slumlord. That’s not the right comparison for owner-occupied housing stock.

As for always being able to rent it out, take a look at the vacancy data: census.gov/hhes/www/housing/hvs/qtr110/q 110tab1.html Whatever that is, a seller’s market it ain’t.

Posted by wcw | Report as abusive

“prices are bound to fall sooner or later, when interest rates rise”

You only address one side of the equation of affordability.
If all else equal, sure, prices will fall. But what if we are in the throws of a decent recovery such that wages are rising healthily?
Then affordability will be going up, not down.

You need to take both into account.
And I suspect(/hope) that the Fed won’t raise rates until I am getting fantastic 10%+ annual pay rises (ha, ha, I wish…)

Posted by TinyTim1 | Report as abusive

“hsvkitty, it was (and is) the last link in the blog”

It is and I apologize for running my cursor over the blog rather then doing a wiser and simpler “find.” (I cannot easily discern the light blue) I should have known you would find the chart and add it.

Posted by hsvkitty | Report as abusive

Question for wow: Would you please re-post your link to the census bureau data? The one you posted takes me to a dead end and I wasn’t able to find in the bureau housing data.

Thanks, JH

Posted by calibadger | Report as abusive

wow follow up:
Never mind, found it with some more digging around the site. Here’s what I believe you were linking to:

http://www.census.gov/hhes/www/housing/h vs/qtr110/graph110.html

JH

Posted by calibadger | Report as abusive

hsvkitty, not good that you can’t see the links. Would a different color be better, or do you need them to be underlined?

Posted by FelixSalmon | Report as abusive

Jobs!

Posted by csodak | Report as abusive

Felix, need underlining , but would prefer a time machine back trip 10 years to where my eyes were normal. 20 years if you can swing it. Thank you so much for your consideration!

(I guess I am the only old fogie who can’t see light blue..so seriously, don’t change it for me. The blog will look better without the lines.)

Posted by hsvkitty | Report as abusive

“The big picture, in terms of house prices and interest rates, is clear: prices go up when rates are falling, and they go down when rates are rising.”

Generally true, however there are other factors (such as a large overhang from foreclosures) that are holding prices down. If I had to guess, I’d say housing prices are more likely to fall over the next three years than to rise.

Yet even a further 15% decline would be a losing proposition if it is accompanied by a 1% increase in interest rates. And all it would take is a hint of inflation-panic to pop the current bond bubble, sending interest rates back up to a more normal range.

If you can find the right home at the right price, and will own it for a long time, then go ahead and buy. Trying to second-guess the direction of the affordability index is a fools’ game.

Posted by TFF | Report as abusive

As per my research it is beneficial to pay long term interests as you have to pay fewer installments per month. However, in a very long term payment, which is for more than 10 years, the overall interest to be paid is more.

Posted by Terms | Report as abusive

It is a double edged sword. Somewhere down the line these low payments would catch up and then the homeowners would probably end up paying the difference.
Real Estate Short Sale

Posted by AnneL | Report as abusive

Reporters tried to interview the Ying Ying, but all immersed in the new joy in the hope to keep some personal space, did not accept interview

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