solution to ending housing crisis: higher interest rates
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?
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?
Comments
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!
Um, you know in the gangster movies where they take a guy, set his feet in cement, tie his hands, and then pull a bag over his head before throwing him in the water. The guy then is sinking, and doesn't know what to do so he starts frantically trying to get the bag off his head. He does, but then you see his eyes bulge and he drowns anyways.
That's Paulson right now, trying to do anything "constructive" at all.
I want to SELL when rates are low and prices are high. 8)
The common argument around here seems to be that if interest rates rise, then prices will come down to the point where the payment (which is all that seems to matter these days) is the same. So if that occurs, why does a higher interest rate increase the ability of the buyer to service the loan? The payment would be the same... The DTI ratio would be the same.
If houses are cheaper, but interest rates higher, and payments *presumably* the same (or similar), why would the loans be less likely to default at a higher interest rate? If anything, I would think that loans with a lower interest rate are less likely to default given an equivalent monthly payment. This would be because a lower interest rate allows for quicker payment of principal in the early years and so more quickly gets that cushion of equity in case the owner needs to sell in a hurry.
I think the only situation in which high interest rates are good is one in which they are very quickly followed by lower interest rates.
If everyone makes only the minimum payment, you're right. But if you make just one extra payment with high rates/low prices it can cut years off the mortgage, and offset the rate at which equity is payed. Now for a reduction to absurdum.
You buy a $3,000 house with 100% interest per month. Your monthly payments are (making this up) $2,999.99. You're building equity really slowly and paying a lot in interest. But, pitch in an extra $20 one month, and you're suddenly over the hump. That $20 means you'll pay the mortgage off in less than a year now (assuming you keep paying $2,999.99). Meanwhile, if you don't make that extra payment, a large portion of your money is going to interest which at least you get a tax break on.
Conversely, if you bought with 0% interest, the same payment would give you a $1,080,000 house. We are assuming that payment affordability is all that impacts prices, so for over $1 mil you get the same exact house. Now, you get no tax deduction, and extra payments don't help you out at all. But hey, you're building equity "quickly".
Real world numbers are not as extremely, but this shows why high rates are better for buyers than lower rates, but low rates are of course better for owners (just refi!).
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!
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!