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Residential Department: BackSpace: April 2017

 

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Rising interest rates will not make the sky fall

After falling to near-historic lows this past year, mortgage interest rates increased at the end of the year, hitting 4 percent for the first time in 18 months this past November. The Federal Reserve is expected to increase short-term rates three more times this year, making some experts believe long-term rates could reach 4.5 percent or higher by the end of 2017. That would be an increase of more than 1 percentage point over rates in the 3.36 percent ballpark this past August.

Many housing experts are concerned these rising rates could adversely affect home-price growth, housing affordability and the financial health of the mortgage industry. In Zillow’s Q1 2017 Home Price Expectation Survey, 56 percent of respondents named “rising mortgage rates and their impact on mortgage affordability” as one of the top three market forces that will impact the housing industry this year.

Others believe these fears may be un-founded, however. They say the sky, it turns out, is not going to fall on the housing market.

Home-price growth

Ralph DeFranco, global chief economist for Arch Capital Services, has charted the history of interest rate increases during non-recession periods, and his data shows that rising interest rates don’t cause home prices to decline. “It calms down the housing market,” says DeFranco about rising interest rates. “So, if home prices are growing rapidly, they just grow at normal levels.”

DeFranco believes that if long-term interest rates increase to 4.5 percent this year, home-price growth will most likely slow down to around 3 percent — down from the 6 percent to 7 percent increases over the past two years. He also says historically these price-growth slowdowns have only been temporary, and price growth rebounds quickly after interest rate increases.“I think the history is kind of comforting,” he says.

Mark Zandi, chief economist for Moody’s Analytics, also believes that rising interest rates will have only a modest impact on home prices this year. “Rates are rising because the economy is good,” says Zandi, “meaning unemployment is low, [and] recruiting, jobs and wage growth are picking up.” Zandi goes on to say, “I think the negative effects of the higher rates will be offset by the positive effects of the still-good job market and net housing should be fine.”

Affordability impact

So, what about affordability? If home prices continue to rise, albeit at a slower rate, and mortgage payments get more expensive because of rising interest rates, won’t this adversely affect housing affordability?

Mark Palim, vice president and deputy chief economist for Fannie Mae, believes affordability will take a hit. He says Fannie Mae is forecasting that home sales will only increase by 1.6 percent this year, even though incomes are projected to grow by 2 percent to 3 percent. “It’s the double whammy of higher interest rates along with continued strong house-price appreciation that is definitely eating into afford-ability,” Palim says. “It puts a dampening effect on unit sales.”

It’s a tricky thing— normalizing interest rates — and the Fed has had mixed performance on that.
— Mark Zandi, Chief economist, Moody’s Analytics 

DeFranco says some people at the margins will be priced out and that some borrowers will always hesitate in “the face of rising interest rates,” but he says rising rates, like price growth, will cause only a temporary slowdowns in sales. DeFranco believes the market can handle increasing rates, even if they rise quite a bit. “Affordability,” he says, “even at 6 percent [interest] would be basically historical-average affordability. I think it’s safe to say that we can move up from here without causing much problem.”

Zandi expects affordability to remain roughly where it is now because gains in income will offset the impact of rising prices and interest rates. He does concede that “low- and middle-income households are the most sensitive to rates” and are “more on the edge with regard to affordability.”

Zandi believes increases in construction will help ease the issue of affordability at the lower end of the market, however. The key, according to Zandi, is the recent home-price appreciation. “You got builders that have land at high basis, purchased pre-recession,” he says. “You can’t make money on that land until house prices rise sufficiently.” Zandi believes more builders will begin building at lower price points as housing prices return to pre-recession levels across the country.

Problem areas

Rising interest rates will have an impact on refinance production this year, however. The Mortgage Bankers Association has stated that the volume of refi originations could drop by more than 40 percent in 2017, down from nearly $1 trillion in refis originated in 2016.

“The refi market is incredibly sensitive to rates,” says Zandi, who says that 4 percent rates are the breaking point. “That’s when you go from this thing [refinancing] works economically, to it doesn’t. It’s like a light switch going on and off.”

A bigger issue than the loss of refis could be looming, however. Both Zandi and Palim mentioned the 2013 “taper tantrum” when then-Fed Chief Ben Bernanke mentioned the possibility of ending quantitative easing, causing a 100 basis point jump in fixed mortgage rates within a few weeks. According to Zandi, “That did a lot of damage to housing back in 2013 and early 2014.”

Another period of risk could be on the horizon, according to Palim. He says once the short-term rates reach 1 percent, the Fed is expected to turn its attention to managing long-term rates, possibly by altering how it handles the mortgage-backed securities in its bond portfolio.

“It’s a tricky thing — normalizing interest rates,” Zandi says, “and the Fed has had mixed performance on that.”

Palim agrees. “There needs to be delicate communication of what their policy intentions are and the rate at which they are going to change them so the bond market has time to absorb that,” Palim says. “That’s a period of risk, if that delicate dance doesn’t go right and the market gets spooked.”


 

Will McDermott is editor of Scotsman Guide Residential Edition. Reach him at (800) 297-6061 or e-mail willm@scotsmanguide.com.

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