Economics Paper on The Effect of High Interest Rates on the Mortgage Market

The Effect of High Interest Rates on the Mortgage Market

Every person dreams of owning a home. However, the cautionary that interest rates may increase rapidly has made mortgage owners to experience additional payments. In the past 34 years, the mortgage interest rates have reduced. In 1981, the rates peaked at more than 15% and since then, the 10-year Treasury note operated at 1.83% prior to the 2016 presidential polls (Goodman, 2017). Likewise, primary mortgage amounts (money paid by borrowers to obtain a new 30-year-fixed-rate mortgage) reduced from more than 18% in 1981 to 3.54% in 2016 polls (Goodman, 2017). In 2017, the rates were high as the 10-year Treasury note traded 44 basis points (bps) higher in revenue and rates on 30-year mortgage above 49 bps since 2016 (Goodman, 2017). Increasing interest rates affect the mortgage market in the following ways:

Reduced Mortgage Origination Volumes

Interest rates hit the highest point in 1981 and since then, they have reduced (Goodman 2017). The moments of rising rates have been temporary. The repayment alternative for mortgages has been persistently effected, and this has reformed the mortgage world. Weighted average unsettled coupon shifted from 7.65% in 1999 to 4.17% in 2017 (Goodman 2017). Supposing refinancing needs a 75 basis point discrepancy between the current primary mortgage rate and the note rate for the unsettled mortgage, about 18% of the existing 30-year mortgage world will be refinanceable (Goodman, 2017). 75 bps are estimated from Bankrate data, which shows that the typical mortgagor will be charged $2, 100 on a $200, 000 loan, excluding title search charges or title insurance (Goodman, 2017). Adding the 1% for the title insurance and title search makes the total needed up front for repaying a $200, 00 loan 2.05 %, or approximately 52 bps in absolute expenditures (Goodman, 2017). Moreover, the debtor is required to save a minimum of 25bps due to the hassle aspect.

Reduced Profits and Persistent Industry Consolidations

Reduced mortgage financing will have an effect on profitability. The originators benefit most from refinancing waves when their capacity is limited. Minimizing rates in proportion to the market as interest rates reduce and debtors refinance is unnecessary. Therefore, the originators can raise their spreads and manage to obtain adequate business volume. On the contrary, when rates rise, originators are compelled by competitive pressures to increase mortgage rates to sustain market share.

The low volume, as well as profitability, may imply consolidation in a highly fragmented sector. Origination focus has decreased significantly since 2011. The leading five originators’ market share declined from 64% in 2010 to 29% in 2016, whereas the share of the best 25 originators fell from 89% to 56% within the same duration (Goodman, 2017). Consolidation was also experienced in 2017, and more is expected.

Reduced Prepayment Rates

Decelerated prepayment has been witnessed and is expected to continue declining as debtors who realize the increased rates on the horizon finalize their refinancing. From 2010 to 2017, increased speeds occurred in summer while lower speeds were observed during winter, which partly concealed the deceleration (Goodman, 2017). Such a decline fails to reveal the lock-in impact that will be apparent if rates still increase.

Another factor that leads to decelerated prepayment after reduced refinancability as well as the lock-in impact is the overall decreasing flexibility of the US homes. The homes have witnessed a secular reduction in flexibility for proprietors and tenants from the 1980s (Goodman, 2017). The reduction happened among each age group, race, and ethnicity. Despite the fact that various factors played a role in this reduction, including an increase of dual-career families and capability of working distantly, such factors do not account for the degree of the reduction.

It is hard to know how great the effect that approximately 50% reduction in mobility will have on the mortgage market since the periods of increased rates during the last four decades are inadequate to develop repayment models for capturing this impact. Such repayment rates could be slower compared to what various prepayment models forecast. The current secular deterioration of geographic mobility seems difficult to perceive using prepayment modeling. In case mortgages develop into longer-duration tools compared to what models forecast, the rising rates can result in a larger mortgage sell-off compared to what is expected (Goodman, 2017).

High Home Prices

Increased interest rates affect home prices in several ways. Firstly, increased rates are usually linked to a stronger economy.  It implies that wages are largely increasing, which makes people able to purchase homes, and borrowers are certain of their job status and are ready to borrow to be able to purchase a home. Moreover, increased interest rates are normally related to inflationary periods in which real assets, for example, homes increase in price. Increased interest rates denote risen monthly costs that hamper affordability. Decreased affordability mutes rising home prices.

Rising interest rates are usually positive for home values, notwithstanding declining affordability. In examining the association between the cost of homes  and interest rates in the last 40 years, interest rates increased significantly from 1976 to 1981 (Goodman, 2017). As a result, many families could not afford homes. During that time, home prices increased steadily. After hitting the highest point in 1981, extended higher rates were experienced in 1994, 2000, and 2013 (Goodman, 2017).  During each of these periods, the home price increase was robust. National drops in nominal home prices occurred during the times of economic weakness, which were typified by decreasing interest rates-the Great Recession and the recession in the early 1990s (Goodman, 2017).

Despite the fact that nominal home prices still rose as rates increased, the actual home price growth, determined by decreasing home price upsurges by real inflation, was moderate. Increased nominal interest rates signified high-achieved inflation and inflationary prospects from 1976 to 1981 (Goodman, 2017). The actual cost of a home was negative.

Concerning affordability, increased interest rates indicate higher payments. Higher home prices have both merits and demerits. Robust home price increase enables families to create wealth and amass equity to shift to a bigger home or in a high socioeconomic status region. The majority of Americans mainly acquire their wealth through home equity. Healthy home price increase and rising interest rates also cause the acquisition of a home less affordable for families that do not own homes. In a constricted credit setting, the trend transforms to reduced future homeownership rates (Goodman, 2017).

Persistent Decline of Repeat Homebuyers

Although many people believe that first-time home purchaser activity is low, repeat home buyers are doing badly. The statistics of first-time home purchaser portion for Federal Housing Administration (FHA) as well as government-sponsored enterprise (GSE) mortgages indicate that 83% of FHA purchase mortgage, as well as 48% of GSE mortgage, was taken by first home purchasers in April 2017 (Goodman, 2017). First-time home purchaser share reduced in the early 2000s (Goodman, 2017).

In 2001, the market received 1.8 million repeat home purchasers. Even though the number reduced, until 2009, there were usually more than a million a year. Not more than 700, 000 first-time home purchaser were witnessed in 2009. In 2016, the number increased to about 1 million; however, this figure was 57% of first-time homebuyers in 2001 (Goodman, 2017).

On the contrary, 1.3 million first-time home purchasers were reported in 2001 and 1.4 million in 2016 (Goodman, 2017). The disparity in 14 years were lower compared to repeat home purchasers. The best approach to purchasing a home for the first time is developing a good credit record, acquiring stable income, and having sufficient funds for a deposit. Tight credit minimizes the opportunities of qualifying for a loan. However, a borrower who has a high paying job can afford to make the down payment.

Initially, borrowers utilized the equity in their first home to make a higher deposit on the second home. Nevertheless, less equity has been built up under the current conditions. In addition, actual revenues have been flat, and this has made it hard to make a larger monthly payment. The rising rates will make the lock-in effect to discourage the repeat home purchaser more, as those who currently own homes remain where they are to retain their present mortgage charges (Goodman, 2017).

The Second-Lien Market May Return

For mortgagors who are not likely to shift and prefer to renovate their home, acquiring money for remodeling may not be easy. A decrease in rates leads to prolonged finance waves, making many borrowers to utilize cash-out refinancing. In an increasing rate environment, a cash-out refinance is economically convenient and not refinancing. If debtors requires 10% of their home’s price, they are allowed to retain their 3.5% mortgage and obtain a credit card debt at 18%, or can refinance their mortgage to 4% and over 50pbs in costs (Goodman, 2017). In this context, the cash out refinance is the affordable option.

The second-lien debt is a bad experience, as witnessed during economic crisis. The second liens applied for debtors with higher loan-to-value percentages, which were calculated off exaggerated assessments. Nevertheless, the instrument was satisfactory but it was not well utilized. Texas forbade second mortgages in cases where the loan-to-value proportion of the first and second was over 80%. As a result, second liens in Texas were effective. This market is likely to return since it is valued in an increasing rate environment.

The U.S Federal Reserve has upheld a loose monetary policy, which has kept interest rates low and made acquisition of credit easier. However, since the economy is approaching the highest employment rates and corporate America is making a lot of profits, the Fed’s policy has become tight. Following decades of a fixed 30-year mortgage interest rate below 4%, the rate is currently 4.5%. The latest stock market fluctuation has been caused by the concern of increasing interest rates, and soon the high rates will penetrate the housing industry. The increasing rates may pressurize those intending to purchase homes to acquire them sooner than later since the rates are not likely to recuperate than they are present.

References

Goodman, L., & Bai, B. (2017). The Impact of Higher Interest Rates on the Mortgage Market. The Journal of Structured Finance, 23(3), 45-55.

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