Higher Rates vs. Lower Home Prices

By:
Kirk Haverkamp | July 16, 2011

With home prices continuing to slide, many potential buyers are holding off until they’re confident the housing market has bottomed. But in doing so, they could end up getting burned on mortgage rates.

That’s because a seemingly small change in interest rates can have a bigger impact on your monthly mortgage payment than what appears to be a larger change in home prices. And if mortgage rates go up even half a percentage point, it could wipe out any savings you might realize from even a 5 percent further decline in home prices.
 
Consider taking out a $250,000 mortgage to buy a home in today’s market. With a 30-year fixed-rate loan at 4.5 percent, your monthly mortgage payment would be $1,266.71. But suppose home prices continue to fall? What if, by waiting six months or a year, you could get that same home for 5 percent less?
 
A 5 percent reduction would give you a mortgage of $237,500 (for simplicity, we’re assuming you’re your closing costs and down payment remain proportional). But suppose that in the meantime, mortgage rates on 30-year loans have risen to 5 percent? That would give you a monthly payment of $1,274.95 – more than if you’d taken out the bigger mortgage six months earlier at a lower rate! And if the rate went up to 5.5 percent, you’d be paying $1,348.50 – on a smaller mortgage!
 
Most analysts expect home prices to continue falling through the rest of the year. On average, they’re predicting about a 3 percent drop through the end of the year, though a few expect considerably more.
 
Meanwhile, few expect mortgage rates to continue bouncing along at their near historic lows. Most expect rates to start climbing back toward 5 percent in the second half of the year, on assumptions of moderate economic growth. Freddie Mac currently predicts that 30-year fixed-rate mortgages, which average 4.51 percent this week, will rise to 5.1 percent by the first quarter of 2012, and 5.7 percent by year’s end.
 
Meanwhile, other developments are afoot that could affect the cost of mortgages and/or the availability of credit. Federal regulators are considering a proposal that would effectively require borrowers to put 20 percent down to get the lowest mortgage rates, although many in the industry are pushing for a lower standard for what is known as the “qualified residential mortgage exemption.” Borrowers who don’t meet the standard could end up paying significantly higher interest rates, though how much higher is not clear at this time.
 
The government is also committed to reducing the presence of the FHA in the mortgage market and has set its sights on winding down Fannie Mae and Freddie Mac, which will likely send more borrowers into the fully private mortgage market, where rates tend to be higher than mortgages backed with government-affiliated guarantees.

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