The Perils Of Low Mortgage Rates

Includes: IYR
by: Acting Man

By Ramsey Su

This is real estate by the numbers. It is a simple illustration of the trap Ben Bernanke has set for the real estate market and for future Fed policy makers.

Say you are buying a home today for $300,000. You have 20% down payment, and will finance the remaining $240,000 balance with a 30 year FRM at 4% interest. The monthly payment is $1,146. Using a 40% debt-to-income (DTI) ratio, you only need $2,865 income per month to qualify for this loan. The precise ratio is unimportant. You can use whatever ratio you like as long as you remain consistent. Fast forward three years, and you would now like to trade up to a bigger house, or a better location. What are your options?

Let us assume the real estate market has stabilized. For the purpose of this example, "stabilized" means appreciation has been a respectable 5% per year. Your house is now worth $350,000. QE3 has been slowly phased out and miraculously, mortgage rates only went up from 4% to 5%. If you sell the house, you will net about $83,000 after a 7% commission and closing costs. Once again, using 20% as down payment, you can purchase a $400,000 home.

The financing picture, however,is quite different. The new loan amount, at 80% LTV, is now $320,000 vs. the old loan amount of $240,000. At 5% interest, the monthly payment would increase from $1,146 to $1,718, or by $572 per month. Using the same 40% debt-to-income ratio, you would need to see your income rise by 50% to $4,295 per month to qualify, a rather optimistic scenario.

Summarizing the example, it would cost you $572 more per month, and a 50% pay increase to qualify for the new loan, just to buy yourself $50,000 more house. Most households would find the rewards insufficient to justify the cost.

As the above numbers illustrate, 5% appreciation per year for three years would not be sufficient to offset a 1% increase in mortgage rates. At the same time, if real estate prices appreciate at 5% per year for three years, it would be difficult to continue "QE to infinity". Home owners are trapped and will most likely stay put longer to build up equity while enjoying a low house payment. This is one of the reasons why in spite of the recent healthy price appreciation, no one is rushing to put their homes up for sale, resulting in a very tight on-market inventory.

What if house prices appreciate faster, say at 10% per year? That is already the reality in some of the hotter markets. If this trend continues, the Fed cannot justify any additional QE. Take a look at these new numbers in 3 years time. The house you bought for $300,000 is now worth $400,000. To buy this house, using the prudent 20% down and 80% finance guideline, you would need $80,000 for the 20% down payment. Assuming rates have increased to 6%, the $320,000 mortgage would cost you $1,919 per month. Using the same DTI ratio, your income has to increase by 67% for you to qualify. Is that realistic?

Low mortgage rates are good, when they are the result of an efficient lending system. When they are artificially created, they are like a drug that is very addictive. It is a trap that it is difficult to escape from. The Fed may be understanding some of the consequences and has started to talk about exit strategies. The results have been disastrous.

Over the last two months, the Fed has kept its QE purchases steady. A trial balloon called "tapering" was released. This is a milder Fed strategy than "jaw-boning" and a precursor to real policy announcements. The 10 year Treasury yield was at a low of 1.63% on May 2 and jumped to 2.16% on June 7. The 30 year fixed rate mortgage averaged 3.45% in April. It reached a high of 4.125% on June 6.

Bernanke is hoping that the increase in rates will have no impact on this so-called housing recovery. Mortgage applications, probably the most important leading signal, are already dropping significantly. Other indicators are likely to follow this trend. What if the next round of housing data proves negative and the Fed cannot jaw-bone rates back down? What else can the Fed do to keep rates low, or drive them even lower?

There may be a shortage of single family homes for sale, but there is no shortage of housing. Silver Bay (NYSE:SBY), a single family REIT, provides great rental data for Phoenix, currently one of the hottest resale markets. Take a look at all these nice homes for rent in Maricopa County, many with pools for less than $1,000/month. Vacancy is one of the reasons why the Wall Street single family asset model is not working as planned, forcing latecomers such as Colony to temporarily shelve their IPO offerings.

Back in February, I opined that mortgage rates and single family vacancies would be two advance indicators for the housing market. Both indicators are now flashing warning signs. Many opined that Greenspan kept the Fed Funds rate and other rates too low for too long, resulting in the last bubble. Bernanke may have been quite misguided about lowering mortgage rates in the first place and now he has no clue what to do.

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30 year fixed mortgage rate average – via The Federal Reserve of Saint Louis Research. Failing to fall further in 2013, in spite of "QE to infinity".