April 2005
With interest rates still low it looks as though many people are missing a golden opportunity to benefit from them for the long term. Over the past four years, the economy and the consumer that's driving the recovery have been literally flooded with a powerful combination of tax cuts and cheap money.
While many businesses wisely jumped at the chance to shore up their businesses, households have decidedly not. A part of any investment manager's job is to worry a bit about the future and the recent evidence provided by the red-hot real estate market is worth more than a little concern.
After the recession a few years back, the subsequent bursting of the stock market bubble and then the 9/11 attacks, the policy of the Federal Reserve was to significantly lower interest rates to get the economy going again. It certainly worked. The lowest interest rates in decades spurred a lot of consumer spending. Unfortunately, a good amount of that spending was paid for through increased borrowing.
As you can imagine, the real estate sector has been one of the biggest beneficiary's of this "low interest rate" policy. Lower mortgage rates have undoubtedly pushed up real estate prices across the country. That is good thing. But it also has had some negative effects - from an economic standpoint.
The ability to finance a mortgage and take out the built up equity has all but rendered the idea of actually saving money an old-fashioned concept. It's as if people have started to think, "Why should I try to save part of my hard earned paycheck when my home keeps going up without any sacrifice?" When people start to think this way, it is probably a prudent time to begin evaluating what could go wrong.
A quick glance at the mortgage market gives us a pretty good picture of the poor choices some people are beginning to make. Unbelievably, about 40% of all new mortgages are now based on some type of adjustable interest rate. At a time when long term and fixed rate mortgages are hovering around 6%, this statistic is truly astounding. Granted, an adjustable rate mortgage makes sense in some cases, it is certainly not good for nearly half of all new borrowers!
Not surprisingly, buyers seem to be utterly focused on the size of their monthly payment - not the price of the home or the terms of the financing. As you dig a little deeper, it becomes clear that rock bottom adjustable rate mortgages (ARMs) could have a hidden and looming financial downside. The mortgage industry has little incentive to highlight it - so I will instead.
An increasingly popular type of mortgage is the five-year hybrid ARM with interest-only payments during the early years. It is an extremely enticing offer. A home financed with this kind of mortgage results in about a 30% lower monthly payment than a home financed with a traditional 30-year fixed rate mortgage. Rather than choosing to capture that savings, a lot of buyers are predictably stretching into as much home as they can afford. We are all seeing asking prices that only a few years ago would have made prospective homebuyer's gasp.
The catch with this kind of mortgage is that borrowers will likely pay far higher monthly payments in five short years. Under some very conceivable scenarios, with mortgage rates 2% higher than today, some could see their payments jump by as much as 80%. Sadly, the prospect of refinancing at that point with a 30-year fixed rate mortgage simply won't ease the financial burden. It is a classic case of buying now and paying the price tomorrow. As many readers intimately know, five years is not a very long time from now!
While a real estate downturn hasn't happened in recent memory, it has happened before. Higher mortgage rates could be the catalyst for such an occurrence. For those who stretched into their home with an interest-only loan, even a small drop in prices could leave them owing more than its worth.
While it is human nature to believe the future will be better than the past, trying to plan for the opposite is a much more valuable exercise. While nobody knows for sure the direction of mortgage rates, odds are that now is the time to look at the beauty of low and long-term fixed rate mortgages. Five years from now they could be a distant memory and the economy could suffer from the missed opportunity.
Jason P. Tank, CFA
jason@frontstreet.com