(Author's Note: This article was also published on Seeking Alpha on December 25.)
With the continual prodding by many to initiate 4.5% mortgage rates to pacify the current housing market glut, it's important to distinguish the effects based on two categories of buyers:
1. Existing mortgage refinancing
2. Home Purchase Mortgages
Fundamentally, the problem with this policy is that it is likely to have a minimal effect on latter category. Saskia Scholtes wrote about this in "Mortgage activity surges at US banks" -
However, Scholtes' article indicates exactly what I've been piny about - that lowering mortgage rates will not significantly stimulate housing demand. Here's an example of what I mean:
What if we kept mortgage rates at 5.5% to compensate lenders for lending risk, but awaited a continued aggregate home price decline?
Using Mortgagecalculator.org, I ran the numbers based on a $300,000 home price and a $240,000 loan (though I'm not sure someone buying a $300,000 house will have $60,000 to put down to cover the 20% down payment requirement, but this is an experiment...).
At a 5.5% rate, the monthly payments are $1,712.69. At a 4.5% rate, the monthly payments fall by $146.65 to $1,566.04. The move from 5.5% to 4.5% is a drop of 18%.
Now what if home prices fell 18% from $300,000 to $246,000 (a decrease of $54,000) but mortgage rates stayed at 5.5%? Assuming the same 20% down payment, the loan amount would be $196,800 for a home priced at $246,000 and the monthly mortgage payment would be $1,404.41 - a drop in the monthly payments of $308.28. Which would stimulate demand more - lowering the monthly payments by $146 or $308? Lower mortgage rates will lead to lower housing prices as viewed by the buyer (in terms of monthly payments), but not by as much as lower home prices.
Yes, I realize that this is blasphemy because I'm advocating unchanged mortgage rates and a continued fall in home prices. However, the net gain is that lenders can to more borrowers at the higher rate. Why? Because the extra 1.0% offers a risk premium to lenders that will enable lenders to account for the riskiness of the buyers (we don't pay our bills here in America), thus increasing the number of buyers that would quality for approval. Additionally, a decrease in home prices would lower the income requirements for approval for buyers of this same risk profile. At a lower interest rate (say 4.5%), lenders will be forced to maintain stringent mortgage approval guidelines and the lower rates would have less effect on a buyer's monthly mortgage payments.
Remember - it was cheap money to unqualified buyers that bears considerable responsibility for the housing price mess in the first place.
The counter to this argument is simple - if home prices continual to fall, the number of "walkaways" will increase because more current home owners will be under water in their existing mortgages. This brings us back to why advocates of the 4.5% mortgage rates feel this is a viable proposal to solve the housing problem - these homeowners will be more likely to refinance than walk away. I'm not so sure about that. Using same figures above, will a homeowner that's avoiding the $1712 payment above suddenly begin making payments if at $1566? Probably not. Check out the latest data on loan modification application-to-approval rates with the number of interest-only loans creating first and second-lien situations.
With the continual prodding by many to initiate 4.5% mortgage rates to pacify the current housing market glut, it's important to distinguish the effects based on two categories of buyers:
1. Existing mortgage refinancing
2. Home Purchase Mortgages
Fundamentally, the problem with this policy is that it is likely to have a minimal effect on latter category. Saskia Scholtes wrote about this in "Mortgage activity surges at US banks" -
With average rates for a 30-year, fixed-rate mortgage now at about 5.2 per cent, growing numbers of borrowers have an incentive to refinance to bring down their mortgage costs.It's clear that rates falling to 4.5% would stimulate mortgage refinancing, but not new mortgage approvals. Everyone from my father-in-the-law to our data clients at Altos Research have consistently pointed out the merits of such action. If you're paying 6% or even 5.5%, if would naturally be in your personal financial interest in the long run to refinance to a lower rate.
But tighter underwriting standards for prospective borrowers, combined with funding and staffing difficulties for mortgage originators, are likely to restrict the supply of new mortgages.
However, Scholtes' article indicates exactly what I've been piny about - that lowering mortgage rates will not significantly stimulate housing demand. Here's an example of what I mean:
What if we kept mortgage rates at 5.5% to compensate lenders for lending risk, but awaited a continued aggregate home price decline?
Using Mortgagecalculator.org, I ran the numbers based on a $300,000 home price and a $240,000 loan (though I'm not sure someone buying a $300,000 house will have $60,000 to put down to cover the 20% down payment requirement, but this is an experiment...).
At a 5.5% rate, the monthly payments are $1,712.69. At a 4.5% rate, the monthly payments fall by $146.65 to $1,566.04. The move from 5.5% to 4.5% is a drop of 18%.
Now what if home prices fell 18% from $300,000 to $246,000 (a decrease of $54,000) but mortgage rates stayed at 5.5%? Assuming the same 20% down payment, the loan amount would be $196,800 for a home priced at $246,000 and the monthly mortgage payment would be $1,404.41 - a drop in the monthly payments of $308.28. Which would stimulate demand more - lowering the monthly payments by $146 or $308? Lower mortgage rates will lead to lower housing prices as viewed by the buyer (in terms of monthly payments), but not by as much as lower home prices.
Yes, I realize that this is blasphemy because I'm advocating unchanged mortgage rates and a continued fall in home prices. However, the net gain is that lenders can to more borrowers at the higher rate. Why? Because the extra 1.0% offers a risk premium to lenders that will enable lenders to account for the riskiness of the buyers (we don't pay our bills here in America), thus increasing the number of buyers that would quality for approval. Additionally, a decrease in home prices would lower the income requirements for approval for buyers of this same risk profile. At a lower interest rate (say 4.5%), lenders will be forced to maintain stringent mortgage approval guidelines and the lower rates would have less effect on a buyer's monthly mortgage payments.
Remember - it was cheap money to unqualified buyers that bears considerable responsibility for the housing price mess in the first place.
The counter to this argument is simple - if home prices continual to fall, the number of "walkaways" will increase because more current home owners will be under water in their existing mortgages. This brings us back to why advocates of the 4.5% mortgage rates feel this is a viable proposal to solve the housing problem - these homeowners will be more likely to refinance than walk away. I'm not so sure about that. Using same figures above, will a homeowner that's avoiding the $1712 payment above suddenly begin making payments if at $1566? Probably not. Check out the latest data on loan modification application-to-approval rates with the number of interest-only loans creating first and second-lien situations.
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