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Crumbling Purchase Power


By Steven Thomas
REPORTSONHOUSING.COM

Rising interest rates erode affordability and make first-time buyers wary of entering the marketplace.

The U.S. economy is finally revving its massive engine. Jobs are beating expectations; unemployment has fallen to prerecession levels; wages are rising at the fastest pace in years; and, inflation expectations have grown substantially. In addition, the Trump administration is planning to ramp up infrastructure spending, focus on jobs, and change trade imbalances around the world—all of which fuel inflation expectations. As a result, there is a lot of pressure on interest rates to rise.

For the past several years, experts and prognosticators across the country had been predicting a substantial increase in interest rates. Yet, one never really materialized. To many, it was reminiscent of Chicken Little’s declaration, “The sky is falling!” Sure, interest rates had their ups and downs; but in the end, they consistently dropped back down to historic lows, below 4 percent.

That is, until this year.

With the election of President Donald Trump in November 2016, interest rates rose significantly, climbing nearly 1 percent overnight. The new presidential administration was poised to lower taxes, increase spending on infrastructure, and reform trade around the world. These policies were seen as extremely inflationary and resulted in increased rates. As financial markets realized that the policies were not going to occur overnight, once again, interest rates dropped below 4 percent.

It was not until the end of 2017 that the rubber started meeting the road with the passing of the new tax law. Interest rates responded almost immediately and began to climb. Following the announcement of trade reform and a trillion-dollar infrastructure plan, there is tremendous pressure on rates today.

The experts and prognosticators may have had their timing wrong, but they understood that it was not a matter of “if” interest rates would rise, but “when.” With the massive manipulation of the monetary policy by the Federal Reserve, the United States has been in economic, uncharted waters, making the art of forecasting rates a less-thanexact science.

At this point, the pressure on interest rates to rise is real. But, after more than a decade of extremely low rates, everyone has become accustomed to these affordable levels. It is time for a brief history lesson regarding interest rates and what they have been in years past:

  • 1981 = 18 percent
  • 1990 = 10 percent
  • 2000 = 8 percent
  • 2007 = 6.5 percent
  • Today = 4.5 percent

Yes, 3.5 percent was a better rate; however, 4.5 percent is still a very low rate in the context of history. Buyers should not wait for another drop in rates. Instead, they should cash in on today’s low rates. Based on the economic history book, these rates are an absolute gift.

Buyers must understand that the longer they wait to purchase, the greater the risk that rates will rise. Rising interest rates erode a buyer’s purchasing power (see Figure 1). If mortgage interest rates climbed by 1 percent from where they are today, buyers looking for a $2,500 monthly payment would see their purchase power drop from $616,750 to $550,375; that’s a $66,375 drop. For buyers looking for a $3,500 monthly payment, home purchase power drops from $863,500 to $770,500, a drop of $93,000. And, for buyers looking at a $4,500 monthly payment, home purchase power drops from $1,110,125 to $990,625, plunging by nearly $120,000.

Keep in mind, 5.5 percent is still a very low rate. The trouble is that there are younger buyers in the marketplace who have never experienced rates above 5 percent. The housing market is not going to implode. It will not be the end of the world. But, it will eat into purchase power. That 1 percent increase in mortgage rates will result in an 11 percent drop in affordability.

With an improving economy, the new tax law, trade reform, and a new infrastructure plan, expect mortgage interest rates to rise. Buyers should not sit on the sideline and wait for them to drop. If they do, they will watch their purchase power crumble.

Steven Thomas has a degree in quantitative economics and decision sciences from the University of California, San Diego, and more than twenty years of experience in real estate. His bimonthly Orange County Housing Report is available by subscription and provides housing market analysis that is easy to understand and useful in setting the expectations of both buyers and sellers. His website is www.ReportsOnHousing.com.