solution to ending housing crisis: higher interest rates

[sniglet]

Most experts seem to feel that low mortgage rates are critical to helping maintain health in the housing market, and that higher rates will be disastrous. However, I wonder if the reverse might be true.

Low rates might encourage people to buy homes who otherwise shouldn't (i.e. because they can get a low down-payment), and force housing prices up over-all. High mortgage rates, by contrast, reduce the number of people who are able to buy homes, and ensures that a higher portion of buyers have the wherewithall to actually own a home.

Yes, I can well imagine there would be a lot of pain in the real-estate market if mortgage rates were to rise to 12% next week, but maybe that would be EXACTLY the kind of purgative action that would restore health, and allow things to recover. Many existing lenders would hurt enormously from a further decline in property values and higher foreclosure rates (that would result from a significant rise in mortgage rates), but new lenders (i.e. unencumbered by existing dead assets) would be able to start afresh with a high level of profitability. They could have a high confidence that the new loans they write at the new interest rates would not default (i.e. because the homes would be considerably cheaper, and more in-line with incomes).

By keeping interest rates low, perhaps the only thing that the government will accomplish (i.e. since it is subsidizing mortgage rates via the GSEs) is to drag out the real-estate crash for years to come. The low rates keep house prices artificially high while making it hard for the private lenders to make any money.

Is this the real solution that Paulson ought to be advocating?

[ira s]

The low rates keep house prices artificially high while making it hard for the private lenders to make any money.

If that's the case, imagine how much farther house prices would have dropped in places like Florida, Las Vegas, So Cal if interest rates were high? Eek!

[rose-colored-coolaid]

[Robroy]

I want to buy in a market where rates are high and prices are low. Then when rates drop I refinance!

I want to SELL when rates are low and prices are high.

[Notabull]

[rose-colored-coolaid]

[Hyperbola]

Er, actually, for your example to make sense, your monthly payment would have to be exactly $3000 for most of the 30 years. With interest rates that high, even paying down the principal by one cent creates an exponential wave of equity accumulation, which is, of course, the point!

I have a much more mathematical way of thinking about this. An amortizing mortgage is equivalent to the sum of an interest-only mortgage and an annuity, both at the same interest rate, where all payments above the interest due are added to the annuity. Thus, you have a fixed interest payment every month that never changes, plus equity that expands exponentially until it equals the principal on the loan.

You deliberately set up your analysis so the minimum payments are the same. Also, in both cases, let's assume the loan principal stays the same as the house value, so there is no positive or negative equity there. The only difference is the interest rate on the annuity! So now it becomes obvious that, given a monthly payment, higher interest rates are significantly better for the buyer.

An interesting and counterintuitive result, as we instinctively see the interest rate as representing money thrown away. And strictly speaking, for different interest rates on the same principal, it is!

[Robroy]

I confess that this whole meltdown has cause a significant paradigm shift for me. What I now see as intuitively obvious (high interest rates are good for borrowers) is a concept I did not even entertain until just a few months ago.

[Hyperbola]

As an aside, this thread also shows how profoundly different an amortizing mortgage is from an interest-only mortgage, or any adjustable-rate mortgage. And it all has to do with the hidden annuity.

Anyone who makes the minimum payment on an interest-only mortgage is sacrificing the entire benefit of the annuity, as there are no contributions at all. Paying above the minimum on a consistent basis is fine, but the interest rate is higher than a 30-year, so either your total monthly payments would be higher or your buying power would be reduced.

Adjustable-rate mortgages add the additional risk of fluctuating interest payments. Note that an interest rate that adjusts higher doesn't help you even though the annuity return is better: your principal doesn't adjust downward to keep the monthly payment the same like it does while you are still waiting to buy the fixed-rate mortgage.

So there really is a logical basis to the idea that fixed-rate mortgages build equity and interest-only mortgages don't. Of course, once you add market risk and the house price starts moving, all of this gets lost in the fog!