My reference point for interest rates on housing is 1985. Your mom and I bought our home in Appleton and the loan on the property carried a rate of 11.5%. That was a preferred rate.
During the next 10 years we refinanced 3-4 times to take advantage of lower rates reaching 5.5%. Each time we refinanced, we reduced the amount of our monthly mortgage payment and we had extra cash.
The prevalent psychology is “we were making monthly payments on our house and living okay, with lower interest rates we can afford a lot more house for the same payment”. So people buy bigger houses. In addition, creative financing has increased the monthly payment you can afford, i.e., adjustable rate mortgages that can go up or down with prime rates, interest only mortgages, and guaranteed low mortgage rates for 3-5 years before “normal rates” would take over. All this demand for bigger houses pushed prices up. At the same time, the minimum down payment for a house went from 10% to 5% to “no money down”.
The second part of the housing bubble is home equity loans. You can get home equity money at low rates but you lose the amount of equity you carry in your home. My observation is that appraisals are really loose, allowing people to borrow lots of money easily. Historically, if you borrowed up to 80% of the value of your home, you were maxed out. No longer. You can in some cases borrow 120% of the appraised value of your home.
Our U.S. economy has stayed buoyant because people have been tapping into home equity.
Now the other side. What goes down, must come up. Interest rates are going up and it looks like short term rates are headed for 4-5% as measured by the Fed. Rate. That means rates on home equity loans are moving to 6,7 and 8% at some time in the next year, or two or three. Adjustable rate mortgages will force people to make higher monthly payments as rates rise. Less people will want to move to bigger houses because they cannot afford the monthly payments. People that lose jobs will not be able to afford their existing large monthly mortgage payments. Value of homes will start to slide down because there will be less buyers wanting new homes.
So what do you do? What do you do?
Assuming you own your home and are comfortable, lock in the lowest interest rate you can for the whole term of the loan. If it is a 30 year mortgage, pay a slightly higher interest rate but know that it cannot go higher while you own the home.
Resist home equity loans. If home values ever start to fall, you could end up with a mortgage coupled with a home equity loan that exceeds the value of your home. That means your property equity is 0 or less. As an example, you borrow $125,000 with various loans and then home values drop. Suppose you can’t make monthly payments for whatever reason and the bank forecloses on your home. The home sells at auction for $100,000. You still owe the bank $25,000 after your home is taken away from you.
Personally Grasshoppers, prudent financial advice is to maximize the equity in your home by paying down the bank loan over time and resist taping into the home equity. There are exceptions to the rule, but they need to be very compelling.
I do know that home values are very high (over inflated), people are over extended with their monthly payments, real estate appraisals are very loose (in some cases ridiculous), job security seems to be a fleeting dream and interest rates are headed up. Those are all the ingredients to pop the real estate bubble. Don’t get caught in the splash.
These are interesting times!
Love,
Dad