Sep 8 2008 1:38PM | Permalink | Email this | Comments (0) |
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While debates rage on when we will find the bottom in home prices declines, intelligent buyers who’ve been waiting on the sidelines should be paying attention to mortgage rates as well. Beyond credit quality and the type and length of loans, two factors influence how consumers buy a home—the price of that home and the interest rate of the mortgage.

The price of the home and the interest rate of the mortgage each have a significant impact on the monthly payment, so assuming would-be buyers are trying to time the bottom on when to purchase a home, ignoring what is happening to interest rates and where they are likely headed could lead to regrets.

As an example, I’ve taken the monthly median home price ($210,900) and the average rate on a 30-year fixed conventional loan as of July (6.5%). I have assumed a 20% down payment and have come up with a monthly payment covering principal and interest of $1,066.

So, let’s assume a median family, whom we’ll call the Smiths, was considering a home purchase. They’ve found the home they want as it addresses the space and lifestyle they imagine for their growing family (one child and a second one on the way). They know they need to move sometime in the near future, as the two bedroom apartment they rent in a poor school district simply won’t provide what their family needs as the elder child enters kindergarten next year and the new child challenges everyone else’s sleeping patterns.

The Smiths have good credit and qualify for a mortgage. They have the means for a full 20% down payment.

They live in an average market, where home prices have fallen somewhat but nowhere near the headline grabbing declines that occurred in California and Florida. They are hearing mixed messages about prices now. The headlines keep referring to year-over-year declines on some index. They are confused about why comparing an index to last year matters—they want to know how prices have changed lately.

A smart friend, whom I’ll call Sarah, encouraged the Smiths to think about both where interest rates and home prices are likely to head. She laid out a simple matrix like below. In the middle they see the monthly payment of their dream home is $1,066 at July’s price and interest rate.

To frame the choices, Sarah asked the Smith to pick a range for prices to fall or go up. They choose a simple 10% up and down. Likewise, they chose to look at interest rates using a simple 10% up and down (or 65 basis points up and down).



Now the Smiths can see nine overall possibilities based on whether interest rates and home prices go up, go down or stay the same. This is helping the Smiths see that changes in interest rates have a big impact on the monthly payment—almost as much as the price.

Sarah then asked the Smiths to think about what is likely to happen over the next year with both prices and interest rates. To help them with some historical context, she shared the following chart showing the average 30-year fixed rate along with the median home price and the consumer price index since 1984.



The Smiths can see that home prices basically tracked along consistent with inflation until the beginning of this decade. While prices have fallen dramatically from their peak, they may have a bit further to fall. Interest rates seemed to be near all time lows. While they have been a bit lower, they’ve been going up.

The Smiths then came to a starling realization. If they are betting on prices falling so that they fall in line with some average appreciation rate and if they expect the same for interest rates, at least across this period that average mortgage rate would be 8.29%, or 179 basis points above the current 6.5% rate. In other words, it would be rational to believe that rates could increase more than 25% above today’s rate.

But, they don’t really think that will happen in the next year even though they are hearing a lot about how the Fed should be defending the dollar and fighting inflation. So they decided to stick with the 10% rate increase risk.

They came up with the following assumptions for the next year: For home prices they think there is a 60% chance of prices remaining where they are in their market and only a 10% chance of an increase of 10%. Therefore, they put a 30% probability on a 10% decrease.

For interest rates, they decided that there is a 20% chance of interest rates falling 10%, but they fear a 50% chance of interest rates rising 10%, which leaves a 30% chance of interest rates not changing.

Sarah took the percentages they assigned and created a weighted monthly price calculation. The result was $1,067, or $1 higher than the current calculated payment. That made the Smiths laugh. “You mean we’ve been sweating over where prices are going and what we’ve been worried about is a dollar?”

Sarah remarked that it is funny how their calculation turned out, but it’s different every time based on assumptions about price changes and interest rates. What made the Smiths calculation so close was that the worst case and best case scenarios were almost even from both a probability and price scenario. That was of course driven by the fact that although they did think prices were 90% likely to be the same or lower, they conversely felt that interest rates were 80% likely to be the same or higher.

So in other words, their own assumptions showed no value for waiting for prices to fall because interest rates could also go up. Based on their feelings, the choice about buying should be less about current price trends and rates but rather about founding the home they want and being ready to move.

Of course this example is very simple as I only used a simple 10% up and down scenario for both prices and rates. The reality is that we have a continuum of possible future states, but I believe this simple analysis should be close to framing the most likely scenarios. If so, like for the Smiths, the value in waiting solely for belief in prices falling is soon to be offset by risks of interest rates rising.

If builders and realtors want to get sidelined buyers back in the market, they need to hire Sarah and help consumers understand they should be watching interest rates as much as prices.