Sunday, January 23, 2011

High Interest Rates Are Good for the Future of the Housing Market

Why High Interest Rates Are Good for the Future of the Housing Market and for Those Buying Houses

1. Higher interest rates would lower prices
The first and most important reason that high interest rates would be good for the housing market is that it would lower the price of housing to what a normal individual can afford.
Prices of houses are not truly determined by what one is willing to pay for the house; it is determined by what one is willing to pay per month for the house. A homebuyer really doesn’t care if his house costs $100,000 or $1,000,000 – he cares whether his monthly mortgage payment is $1,200 or $1,300.
Thus, on the margin, the price of housing is determined by the cost of borrowing. If interest rates are 5%, the mortgage payment on a 30-year $100,000 loan would be about $536. If the interest rate is raised to 10%, then a mortgage payment of $536 would only be enough for a 30-year loan of about $61,100.
These lower prices would obviously make life very difficult for many people who own houses and are underwater. However, one of the key insights of the Austrian Business Cycle is the realization that the quicker liquidation of bad investments happens, the better. Trying to keep prices from falling is the worst thing that we could be doing. With a drastic fall in house prices, many who are currently paying back their mortgage with hopes of future appreciation will realize that they made a bad investment and will liquidate. Society will instead find new, better ways to use scarce resources. At this point, anything which will help break people out of their paralysis will be beneficial. 

2. Lower prices lower the amount you need for a traditional down payment
One of the most difficult steps for a new home buyer is finding or saving enough money for the initial down payment. It always has been. The recent goal of the government has been to reduce the percentage one needs to get a mortgage, which is how many people have managed to qualify for 3% down payments.
As any recent student of history knows, these low down payments have led to many people buying houses they couldn’t really afford. True, most could at least make the monthly payments when everything went right… but as soon as anything went wrong, they had no safety net of saved money to tide them through. Further, with so little initial equity, it was very easy for many people to have a depreciating house which led to negative equity. In fact, it was possible to roll many of the costs of the loan into the mortgage and to start off with negative equity. When houses didn’t appreciate, and they ran into any financial hardship, borrowers were trapped.
Lower prices, however, reduce the amount of a traditional down payment without leading to little or no equity. A $100,000 dollar house would need a $20,000 down payment to be at 20%. Some banks and regulators are now even talking about the need for 30% down payments. But what if the price of houses fell 40%? Then, even with a 30% down payment, you would only need $12,000 to buy the same house. Further, you would still have an $80,000 mortgage in the first case and only a $48,000 mortgage for the second ($52,000 if 20% remains the "standard" and your down payment was $8,000).
True, $12,000 is a lot more than the $3,000 you might need now for a down payment… but that means it will help weed out many of those who are incapable of paying off a mortgage because they cannot or will not save for the future. Proof of ability to save may be the most important indicator of ability to pay back a loan.

3. Higher interest rates will make it easier to build up that down payment
Not only will the amount needed for a traditional down payment drop, but higher interest rates will make it easier to save up for the down payment. Clearly, with higher interest rates, the incentive for people to save rises. Today, you might get between .5% and .75% saving money in the bank. It would take a very long time for any interest from that to help you towards your goal of a down payment.
If, however, interest rates from banks were 5% or so, the interest you would be earning would be enough to actually make a dent.
For example, let’s say you need to save $20,000 for a down payment, and your budget will allow you to save $4,000.00 a year. With 5% compounding interest, it would take slightly less than 3.5 years to save up $20,000. With .5% interest, it might as well take you a full 5 years.

4. Lower prices make repayment of the mortgage easier
When I was growing up, it was not unusual for people to pay extra towards their mortgage so as to pay it off faster. However, lower prices with higher interest rates makes this process much more economical.
Imagine you are in a situation where you are making the minimum mortgage payment of $536 a month for one of the two mortgages in section one, but you bought less house than your maximum budget. You have, instead, $636 a month to spend.
In the $100,000 mortgage situation, you would pay off your home in 21 years and 5 months, and would spend about $62,675 in interest.
In the $61,100 mortgage situation, you would pay off your home in 16 years and 4 months, and would spend about $62,257 in interest.
Given these numbers, you could pay off your house over 5 years faster with the higher interest rate, and you’d even pay less in interest during that time.

5. Lower prices reduce taxes and insurance payments
As most home buyers know, there are more costs in owning a home than the mortgage payments. The two biggest ones which are regular are insurance and taxes.
Many states charge taxes based on some calculated percentage of the value of the home. Thus, a 40% drop in prices would result in a 40% drop in taxes in many areas as well.Similarly, some states use housing values to determine insurance rates. Those states would see a reduction in insurance rates as well.
Thus not only would the cost of the mortgage go down, many of the other costs will fall as well, which will lead to even smaller mortgage payments. 

6. Higher interest rates will eventually lead to more buyers.
As shown above, the more interest rates go up, the more prices will fall, both for the mortgage and for other costs associated with house payments. As every economist knows, when the cost of something falls, the quantity demanded will rise, all else being equal. This will bring new buyers into the market, and new buyers will help us move through this housing glut.
For the current homeowner, this may hurt financially, obviously. They will lose everything they have put into their houses and, depending on their contracts, still be saddled with some debt. Bringing more buyers into the market and teaching current home owners that they made poor decisions will, however, help bring an end to the stagnation of housing market. Ending this stagnation is in the long-term interest of every person.
For any potential home buyer, higher interest rates are actually much more helpful than the current low interest rates which artificially raise the interest rates, as high interest rates will lower prices, make it easier to pay down payments, and make it easier to pay off a mortgage at an accelerated rate.
Thus, the great fear of many politicians of "rising interest rates" is not the horror story they imply, but the best thing that could happen to the housing market.

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