Rates vs. Rates of Change

Submitted by Rich Toscano on July 27, 2006 - 5:15pm

During the Take 5 taping, my counterpart from SDAR frequently mentioned that today's low rates (in comparison to those in the 80s) are a good reason to buy. There was no time for me to address this topic on the show, but it gives me a good opportunity to rehash some related thoughts that I wrote for the May credit market update:

People argue that home prices are unlikely to decline because rates are still historically rather low, but that makes little sense. The raw level of rates is irrelevant in determining future price movements. What matters in this case is the directional movement of rates. If rates are historically rather low, that actually strengthens the case that they could rise to more normal levels and thus put downward pressure on home prices in the future. If that happens it will clearly not be good for home prices.

We need look no further than the current environment to see this dynamic at work. Last year at this time, the permabulls were telling us that home prices wouldn't decline because rates were nice and low.

June 2005
June 2006
Loan Amount
Rate, 30-Year Fixed
Rate, 1-Year ARM
Payment, 30-Year Fixed
Payment, 1-Year ARM

Well, look what's happened since then. The table above measures the effects of rate changes by comparing the carrying costs on a mortgage today vs. one year ago. Assume a loan of $500,000, because this is a typical loan you might take out to purchase a middle-of-the-road single family home, but mostly because I like round numbers.

Monthly payments on a given loan amount are around 12% higher for fixed-rate loans and 19% higher for adjustables than they were at this time last year. Conversely, a buyer with a maximum monthly budget must make do with a home that is 11% less expensive (for fixed mortgage users) or 16% less expensive (for ARM users) than they could have bought last year. That translates into a decline in purchasing power, plain and simple. It's just that much harder to buy homes at these ridiculous prices. Last year's unnaturally low rates were far from the blessing that the bulls would claim—they were a curse, because such low rates were destined to rise to levels that would put downward pressure on future home prices, as they have done.

In short, the idea that low rates are supportive of price appreciation has things completely backwards.

If you are discounting future income streams on an investment property (not that one gets any income off of San Diego properties at current prices), then low rates work to your advantage because they effectively render the future income more valuable.

But if price appreciation is your concern, then you are better off buying when rates are high and headed lower, rather than when rates are low and headed higher--as they appear to be now.

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Submitted by powayseller on July 27, 2006 - 7:32pm.

This argument made by the liars, errr, I mean the bulls, is another reason I am so cynical of the "experts". They KNOW that sales are down due to rising prices and high interest rates, yet they spin the low rates to the public. I hope everyone understands why I have lost patience with the "experts".

I bet you wish you had added this topic to your interview. On these interviews, you really get better after having done a few, so you know what points you want to raise. I can't wait to watch it though, and may you get many more interviews. You'll do better on each one.

Submitted by VanMorrisonFan on July 28, 2006 - 9:25am.


Good analysis. Note also that the costs of other things is increasing (especially fuel - no small item in this age of long commutes and SUV's). Incomes are going up, but very little in relation to the increased price of money (interest rates) and fuel (transportation).

A household unit (family or single) only has so much dough every month to spend (unless they want to start charging everything, which is an entirely separate subject). Something has to give...

Submitted by powayseller on July 28, 2006 - 5:06pm.

bmarum on the thread "health care technician..." says that many people he knows have jobs with guaranteed steep pay increases, and many people will be able to afford the higher payments when their ARMs reset. He was upset that I couldn't see that. He still hasn't told me which occupations have a 30-50% salary increase in the next 3 years. I've asked him a second time.

Does anyone know of any jobs in SD that would increase pay by 30%-50% in 3 years? Some adjusted payments are 70% higher, so I'm just being conservative in my request.

Again, this question is not about which jobs are high paying, but which have a pay increase to match the higher payment, i.e. the rate of pay increase matches the rate of ARM increase.

Submitted by SDbear on July 30, 2006 - 11:16am.

You need to stop harping about this. Bmarum never said that he knows MANY people having jobs with steep pay increases. He was giving an individual instance and in a later post he explained his friends' situation. Other members (including me) posted instances of people having such pay increases. And in ALL these posts NOBODY indicated that increased payments will NOT be a problem for the OVERALL MARKET. All they were trying to say was NOT EVERYONE with an ARM is going to be in trouble.
If you have still not followed what people were trying to tell you here is a summary.
1. Doctors doing residency will have huge (more than 50%) income increases when they start practice.
2. Lawyers making partners in a firm
3. Software and hardware engineers starting out can have huge increases (more than 35%) in the initial few years.
4. Profs obtaining tenure and getting more research grants can easily double their salary.
This is a small list with guaranteed increases that I can come up with off the cuff. While I agree these people do NOT MAKE THE MAJORITY of ARM holders, there are people in these situations who have an ARM. QUITE A FEW of ARM holders took an ARM because they found it to be more economical than a fixed rate loan during the time they took the loan. MOST of them would make the increased payments without any change in their spending patterns.
A lot of people (please note I'm NOT saying ALL) in SD are a lot smarter than what you think they are and sometimes what they want others to think they are. They are confident enough about their decisions that they don't need to convince others that their decisions were good.
While we all agree (and are already seeing it) that the market is going down, we need to be on our toes and not be blind sided as to how far this will go down and how long. And being overly pessimistic is surely not the way.
Like sdrealtor mentioned in another post, predicting with CERTAINTY that RE will go down a certain 50-60% is as irresponsible as saying RE will always go UP.

Submitted by powayseller on July 30, 2006 - 2:40pm.

Thank you for the input. In my analysis on another thread, I added your idea, and assumed that 25% of borrowers with adjustable mortgages would be able to make the higher payments. It probably is more like 1% or 2%,but this conservative estimate should work for now, since none of us really know how many people are in entry level positions of the type you mentioned.

Submitted by lamoneyguy on July 31, 2006 - 11:09am.

have you read the book, "Ahead of the Curve" by Joseph Ellis? Fascinating read on understanding cause and effect relationships (or lack thereof) in major economic indicators, the stock market and economic cycles. One of his main points is that we are overly obsessed with identifying recessions, when, in fact, the majority of the economic damage has been done from the point at which the YoY rate of growth of consumer spending has declined. That number more than anything else seems to coincide with the beginning of bear stock markets, and recessions tend to come at the end of the stock declines.

We are currently seeing very low rates of growth in YoY consumer spending. Wait until the Refi/Heloc money is all spent.

Submitted by powayseller on July 31, 2006 - 3:49pm.

The data used by Elliott predicted a recession since many months. You can see updated charts on his website. The guy is brilliant, and the first economist I have read who has shown how to predict economic cycles. Using his charts, you can predict recessions, and the upswings that follow.

Submitted by Flash Friday on August 22, 2006 - 6:29pm.

If you take two charts, the relationship of income to home prices and the chart showing the change in debt service you can get a feeling of the corrective forces in action.

The loan data shows the increase in debt service on the fixed and ARM loans, but, the relevant ratio is really the DECREASE in loan amount for a fixed amount of income -36%. The Jones and the Smiths live at opposite ends of Sandy Eggo. Job changes force them to sell their homes and buy the other couple's homes. Last year when they bought their homes they got maximum ARMs. As they try to exchange homes their loan amounts drop by 36%, but their equity was only 10%. They can not afford the same home they bought last year.

A more proper display of the reasonableness of the relationsip of income to home prices would be a measure of the debt service ( loan constant x median home price) / income . This ignores the downpayment which could be factored into the equation. This most recent housing boom floats on low interest rates AND perceived feelings that housing is a good investment. Both are changing.


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