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.

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