For more than 100 consecutive months, the U.S. economy has continued to grow, with real gross domestic product (GDP) per capita increasing by nearly 13 percent over that period of time, according to statistics from the U.S. Bureau of Economic Analysis. Even considering recent market corrections, the outlook for the remainder of 2018 remains positive. A key contributor to this period of sustained growth has been interest rates, which have remained at historic lows over the past decade.
Only in the last two years has the mortgage industry seen rates start to creep upward as the Federal Reserve’s Federal Open Markets Committee (FOMC) began pushing the federal funds rate higher. This was likely a move by the Fed to not only mitigate inflation, but also provide flexibility for when the next economic downturn occurs. In the wake of the Fed’s 0.25 percent rate bump this past March, the federal funds target range was lifted to 1.5 percent to 1.75 percent, which directly impacts short-term interest rates, including banks’ prime rate and credit card rates.
As the global economy continues with its dramatic expansion, coupled with indications from the FOMC of at least two to three additional rate increases this year alone, several questions remain: What will happen to mortgage rates? Will rising rates negatively impact the housing market? And what does all of this mean for mortgage originators who often market their products based on having the lowest rates?
Forecasting
When the Federal Reserve raises the federal funds rate, most people typically assume a similar, corresponding increase to mortgage rates will occur. Last year was a less-than-normal year, however, because even though the Fed raised its rate three times, mortgage rates held steady between 3 percent and 4 percent. Given the current state of the economy and the volatility of the bond and stock markets, 2018 is shaping up to be the year when we may see the impact of rising rates finally hit the mortgage market.
What an increase in short-term rates prompted by the Fed will likely mean is a further flattening of the yield curve, which is when the spread between short- and long-term yields is decreasing. Although there is a popular school of thought that suggests a wider spread between an adjustable rate mortgage (ARM) and a fixed-rate mortgage is needed for an ARM to be beneficial, that isn’t necessarily the case. It is likely, however, that the spread between ARMs and fixed-rate mortgages will not be at a wide enough level in 2018 that homebuyers will need to rethink their fixed-rate decisions.
Adjustable rate mortgages may have short-term popularity this year among borrowers who feel like they missed an opportunity post-correction and with borrowers who have large loan amounts where a modest interest rate savings can turn into a healthy monthly savings. Generally, however, fixed-rate loans will continue to be more attractive than ARMs. It seems as though the best tactic right now for originators when approaching the (small) possibility of an ARM market is the Boy Scout approach: “Always be prepared.”
The real question is: What is the Fed doing with the large inventory of mortgage-backed securities (MBS) it has bought since the recession as part of its quantitative-easing policy? The demand the Fed had for those long-term asset-backed securities contributed to low rates overall. If that demand goes away as the Fed pulls back from MBS purchases via its tapering plan launched last year, either the market will need to pick it up or interest rates will have to rise to entice new market players to buy at higher levels.
One of the main challenges with the MBS assets held by the Fed is that they pay off. This means that even if there is a reduction in the amount the Fed purchases, there is still a market for them, if for no other reason than to maintain what was paid off through refinancing or recent home sales as borrowers move.
Finally, when it comes to interest rates, always keep in mind that regardless of any incremental increases, rates are still at historic lows. Even if rates rise this year, it’s unlikely they will come close to reaching even the average mortgage rate from 1971 to 2017: 8.14 percent. Or, take that one step further and compare today’s rates to the high of 18.6 percent in the 1980s, and anyone can see there is a stark difference between today’s relatively low interest rates and what came before.
Heating up or overheating?
Although the Federal Reserve targeted inflation rate of 2 percent had not quite been met as of this past March, inflation growth accelerated in December 2017 above forecasted trends and continued through this past February. The Producer Price Index (PPI) is steadily increasing and, as a core number with less volatility, it is a leading indicator of prices.
This PPI increase, along with low unemployment rates, could indicate a potential price boost. In addition, there has been an increase in nonpayroll jobs, which is the most important indicator of job health overall. At the same time, wages have recently started to rise, following 2017’s strong job growth, which has sparked fears of inflation among investors who anticipate the FOMC will raise interest rates further as a precautionary measure.
Buyers can move beyond the traditional prequalification and pre-approval process to be fully underwritten at the beginning of the homebuying process.
This, along with algorithmic trading mechanisms, is likely what caused the stock market correction this past February. Since then, however, the FOMC has not indicated a bullish perspective and, as long as the PPI and Consumer Price Index are presenting at current levels, there is a lower probability of the economy overheating.
Inventory challenges
Builders are grappling with increases in the cost to build homes, and this is directly impacting inventory by keeping it persistently low, which also is driving home prices higher. This begs the question: How will this tight housing market affect borrowers who are looking to purchase in 2018? One of the most impactful tools in an originator’s arsenal is the full credit approval, which can help make sure their borrowers put the best offer on the table and ultimately avoid a bidding war.
Rather than having a Realtor include escalation clauses in a bid — which in some markets will top out over the appraised value of the home — buyers can move beyond the traditional prequalification and pre-approval process to be fully underwritten at the beginning of the homebuying process. In this way, borrowers can avoid a false sense of security. Instead, they set themselves apart in a competitive market and ensure that once they are ready to make an offer, they can move fast and jump to the front of the line in any negotiation scenario.
Although this could be the best and most effective tool for the borrower, will this resolve the overall issue of lack of supply? Unfortunately, it will not. The primary factor isn’t a lack of willingness in the building community to build, despite higher prices. It is mostly a lack of available labor, which is the result of multiple factors, including a construction labor force that is not growing fast enough to keep pace with demand and a large redirection of the existing labor force to areas in the country affected by natural disasters.
So, to address the inventory challenge for now, we might see an emphasis on providing truly qualified borrowers, in tandem with a greater desire on the part of homeowners to renovate rather than purchase — albeit, perhaps with some limitations because the labor shortage impacts both new construction and renovation.
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Although interest rates are unpredictable at the moment, as the FOMC pushes the short-term federal funds rate higher, stability will likely return to the market. At the same time, if the Fed’s tapering plan and other factors pull money away from U.S. bonds, yields and rates alike will likely begin to rise to attract more bond buyers. This, coupled with the inflationary pressures created by the recent tax reform bill, could drive mortgage rates higher but, as long as mortgage originators continue to act as mentors and guide borrowers through the mortgage process, there is little reason for concern.
