The Connection Between Interest Rates and Housing Prices
I have seen a number of articles recently about the impact of rising mortgage rates on housing prices. Since January, the average interest rate on a 30 year loan has risen dramatically , from 3.41% to 4.37% on a 30 year mortgage, according to Freddie Mac. There have been a few articles suggesting the housing market recovery will be derailed by rising interest rates, which effectively increase the cost of buying a house. However, the chart below which compares mortgage interest rates versus prices, does not support the premise that an inverse relationship exists. Reading the chart, one would come the the conclusion that housing prices are much more impacted by the state of the economy and markets than interest rates. (Hat tip: Calculated Risk)
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What are the characteristics of a house as an investment?
I am going to look at this question from the perspective of buying the place that you intend to make your home. Buying investment properties or investing in real-estate investment trusts (REITs) may or may not be good investments, however, they have different characteristics than buying a house with a mortgage. Specifically, there are two major benefits which are sometimes overlooked:
- Owning a home provides a hedge against inflation
- A mortgage allows you to borrow money at a very low cost
If you don’t own, your biggest monthly expense is rent!
Around 30% of average family income goes toward paying rent. While housing prices can go up or down in value, rents tend to go in one direction – higher. Since 1953, the cost of renting (shelter in CPI lingo) has been slightly negative in only one year. As you can see in the chart below, generally the cost of renting follows very closely overall inflation as measured by CPI. When buying a house with a fixed rate mortgage, you are replacing a variable, but generally rising monthly expense, with a fixed monthly payment.
Let’s say that you currently pay $3,000 per month in rent and can buy your place for $400,000 per year. You are able to borrow $350,000 for 15 years at an interest rate of 4.2%. Let’s assume that inflation for rentals increases on average 2% per year for the next 10 years.
Likely Monthly Rent In 10 Years $3,656.98
Monthly Mortgage Payment In 10 Years (fixed) $2624.13
While the mortgage payment starts out at about $400 less than the rent, the monthly difference increases to over $1,000 in ten years when factoring in a modest degree of inflation. This example may overstate the difference a bit. There are some costs associated with owning a home that do increase over time, like the cost of repairs and maintenance. However, overall owning a home and paying a mortgage does provide a large degree of protection against inflation.
A Home Allows You To Borrow Money At A Very Low Cost & Buy An Investment With A Very Good Yield
I want to think of buying with a mortgage as two distinct transactions:
1) You are purchasing an asset that provides a yield. In fact, you are your own tenant. Building on the example above, the assets costs $400,000 and starts paying $3,000 per month in “interest”. The initial yield is 9% ($36K / $400K). The example is providing a yield which is better than you will find in your personal case. In many places, the home price to rent ratio is around 18 or an initial yield of 5.5%. Essentially, this is very close to the yield on long-term, higher rated high yield bonds.
2) You are borrowing money at a very low interest rate, both in absolute terms and compared to treasuries. At 4.37% for a 30 year mortgage, you are borrowing money for only 0.66% more in interest than the US government can borrow with a 30 year bond. Without the home as collateral, your borrowing costs would be dramatically higher. Its unlikely that you would be able to borrow money for less than 10%.
Borrowing Money at 4.37% To Buy An Asset That Yields 5.5% Equals A Positive Return, Assuming The Value of Your Home Stays Flat or Rises Over Time
Plus, you get to hedge your biggest monthly expense against inflation!
OK, but what does this have to do with $50,000 worth of bonds?
In the example, I mention that you are buying a house for $400,000 and borrowing $350,000. In the example, you have to come up with $50,000 to provide as a down payment for the house. You could cash in bonds, stocks or other investments. Bank are currently requiring down payments between 15 and 20%.
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