What Happens If Mortgage Rates Soar?

The last time annual mortgage rates topped 5% was in 2009. As it happens, that was also the start of the great bull market on Wall Street. The two events are closely related, and in 2018, that could spell trouble for the housing sector.

The usual equation works like this: Money flows into the investment modality that produces the best return and the least risk. With mortgage rates at historic lows, the “right” option for many investors has been the stock market. But now with rates pushing marginally higher, some on Wall Street are beginning to move money into the bond market. This – at least in part – explains the massive Feb. 5 sell-off, when the Dow Jones Industrial Average fell nearly 1,200 points.

For the real estate sector, the thought of higher rates is strangely worrisome. It’s difficult to see why rates at 4.5% or 5% percent should be troublesome when the typical long-term rate for mortgages is roughly 8.6%. Yes, any rate increase flushes out marginal borrowers, but with interest levels so low by historic norms, you have to wonder why the marketplace shouldn’t be able to easily absorb mortgage rates of 4.5% and higher.

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Part of the answer is that mortgage rate increases produce real sale declines. Lawrence Yun, chief economist with the National Association of Realtors (NAR), estimates that for every 0.1% rate increase, 35,000 home sales are lost annually. If rates go from 4% to 4.5%, it means that 175,000 sales, worth perhaps $43.2 billion, will be lost, and with them, big opportunities to originate mortgages and collect transfer taxes.

As rates began to rumble higher at the end of 2017, NAR reported that December existing home sales “subsided,” a polite term for a 3.6% decline from November. New-home sales fell 7.8% in January 2018 when compared with December, according to HUD. Meanwhile, Ten-X Commercial reported in January that “the commercial real estate sector kicked off 2018 with a whimper. Nationwide, commercial pricing in January fell 0.3% from December’s figures – the ninth consecutive month of contraction for the index. The pricing gauge now stands only 1% percent higher than a year ago.”

Why so much rate concern?

First, the Fed seems grimly determined to raise bank rates. Many believe that three increases of 0.25% each are likely in 2018. Such Fed rate hikes will plainly push up bank rates, but any push with mortgage rates may be less significant: since 2015, when the Fed began its current round of rate hikes, it has increased the federal funds target rate by 1.5%. During the same period, annual mortgage rates rose by 0.14%.

The worry is that with rising wages and little unemployment, additional Fed rate hikes may spur inflation rather than contain it. Given the stock market retreat in early February, there’s now at least some reason to believe that the Fed might opt for fewer rate hikes in 2018.

Second, the government continues to borrow massive amounts of money: $519 billion in fiscal 2016 and $995 billion in fiscal 2017. Thanks to tax reform, the government will add an estimated $1.4 trillion to the budget deficit in the coming decade.

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Government borrowing competes with the private sector for investment capital. The result of such huge demand is a push toward higher interest rates.

Third, if interest rates go up, then bonds become more attractive to investors. That takes money out of the stock market, and the result can be lower share values.

At what point do interest rate increases become problematic? Economists debate such issues, but the bottom line is this: Since 2009, the mortgage marketplace has been a borrower’s paradise. Now it looks like the good times are about to end, and with them, access to mortgage money priced around 4%.

Peter Miller is a contributing writer for Ten-X and Auction.com as well as a nationally syndicated newspaper columnist. He is the author of the 2016 edition of The Common-Sense Mortgage.

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