Rising Mortgage Rates May Cause Home Prices to Go Even Higher

By: Steven Higgins, Financial Advisor, Principal

Turn on the news or walk in to your local coffee shop and it doesn’t take long to hear somebody talking about the raging real estate market anywhere within a $50 Uber ride from Denver or Boulder. This new found personal wealth is a refreshing reprieve from many who limped out of the “Great Recession” 6 years ago. However, the increase in your bungalow’s value may not do you any good unless you’re going to move to out of state and commute. Remember, you can’t take the mountains with you.

The other headline grabbing business news is, of course, the looming rise of interest rates (audible sigh). If you have been a reader of my articles over the last few years then you know I’m tired of writing about “the great rate debate.” It seems the consensus is that as the Federal Reserve (Fed) raises rates all hell will break loose. Stocks will crash, bonds will poison you if you get near them, and real estate will return to it’s natural state … worthless dirt. Let us clarify a couple of things. First, the Federal Reserve only controls the Fed Funds Rate which is the rate that banks lend each other money overnight. Second, all other rates are dictated by supply and demand. Third, U.S. Treasuries are yielding more than their global counter parts and if the whole world, sans America, is keeping rates low, then the world will likely be buying American bonds – likely keeping American bond prices high and American interest rates … not so high.

Let’s talk about those home prices. In the Denver/Boulder area home prices have increased substantially over the last few years. Not only have they made up for what they lost in 2008, they have reached all time highs in many areas. Recently, a local realtor told me that he put in an offer for a client on a home with a listing price of about $250,000. The offer was $30,000 over the asking price and the offer was not accepted. That’s unbelievable! So why are home prices climbing faster than a cat in a flood? Simple. Some demand and very little supply. A quick search on realtor.com for single family homes for sale in Broomfield and Boulder Counties (combined population of about 370,000) revealed less than 30 single family homes for sale under $400,000. Only one home was in the city of Boulder.

Here’s Why:

1. There is very little new building in the area.

Many builders slowed operations after 2008 because of the recession and are slow to ramp up. In addition, local municipalities have put building restrictions in place. Boulder and Broomfield Counties are picky about what can be built where. Finally, Boulder and Broomfield Counties are running out of places to build. Broomfield used to be “out in the sticks” and now it is one of the major business hubs in the Denver Metro area. “It ain’t your Grandma’s Broomfield,” however, if Grandma has lived in Broomfield for a while, she’s likely made a killing on her home.

2. Influx of High Income Earners
The city of Boulder has a very high median home price of $685,000* but that doesn’t keep people from moving there. Boulder experienced net population growth in 2015 of 2,390 people*. In 2015 Boulder only added 697 new housing units with less than 60 of those being single family homes*. In 2014 Boulder had one housing unit for every 2.28 people. The growth in Boulder in 2015 represented only 1 housing unit for every 3.42 new residents. That means that Boulder only added two-thirds of the homes they needed to keep pace. With Google alone adding over 1,000 jobs in the next year, don’t expect this phenomenon to end any time soon.

Rising Rates Could Cause Home Prices to go Even Higher.

This is a contrarian view to say the least. With the 30 year mortgage rate near 4%, banks are not taking any chances. I believe it’s pretty much a public service that they issue any mortgages at all. If a bank lends money for 30 years at 4% and rates just go back to average, around 7% , the banks lose. Picture this, in the summer of 2008, money market savings accounts were paying over 4%. Think of that as a 1 day bond. Can you imagine a scenario where you lent somebody money at 4% per year, locked up for 30 years but you had to pay somebody else 4% just to borrow it over night. It seems to me that if a bank is going to issue somebody a mortgage at a crazy low rate that person is going to need a down payment, a 750+ credit score and great job. If the banks know they are going to lose many on the best borrowers, they sure aren’t taking any risks.

Now fast forward to the apparently all but certain future of higher interest rates. Let’s say mortgage rates are normal at around 7%. The banks may think very differently and now they get to use their arsenal of solutions. At 7%, the banks can lower lending standards, issuing loans to more people. Sure, some of those loans may not work out, but at 7% you can afford to lose a few apples off the back of the wagon.

Also, remember Adjustable Rate Mortgages (ARMs)? Well, they generally don’t make any sense when rates are at record lows. People “fix” loans when rates are low and they use ARMs when rates are higher, hoping for better rates later. Banks have lots of tools available to mitigate high interest rates for eager borrowers. In addition to ARMs, there are interest only loans, balloon loans, 0% down loans, and more. And there is no law that says banks can’t issue loans with terms longer than 30 years. Why not a 45 year mortgage? So, higher rates give banks more flexibility and allow the banks to take risk. In my opinion, that means more borrowers, more buyers, and more demand.

Think Rising Rates will Cause Real Estate Prices to Drop?

Waiting to buy may be risky. Many people argue an increase to mortgage rates will lead to less buyers and price drops. I challenge the logic of waiting to buy based on that assumption. For borrowers (those using a mortgage loan to buy homes), there are two components that make up the cost of buying: home price and interest rate. If interests rates go up causing home prices to drop, the drop would need be so significant that it would offset the effect that the increased interest rate had on the cost of buying the home.

For example, $400,000 borrowed with a 30 year mortgage at 4% carries a $1909 monthly payment (principal & interest). If the home price drops by 10% and the rate is increased by 1%, ($360,000 borrowed at 5%) the payment is roughly the same at $1932 per month. So, we know that somebody waiting for prices to drop before buying a home needs the price of that home to drop by 10% for every 1% increase in mortgage rates. History tells us that likely won’t happen. During the “Great Recession” of 2008-2009 the median home price in Broomfield County dropped by 6%. In Boulder, prices actually increased. Buyer beware. Historically, mortgages average between 6% and 7%.

I’m neither a mortgage broker or a real estate broker. As a financial advisor, I help clients make sound and logical decisions based on the best information available. It’s important to understand, consensus is not always correct. The goal is to have more sound, practical decisions than emotional ones. Real estate is a major component of our client’s financial wellbeing and we certainly take the time to consider the best options.

*Data sourced from 2015 Boulder Community Profile

Securities offered through LPL Financial, Member FINRA/SIPC. Investment advice offered through HD Wealth Strategies, a registered investment advisor and separate entity from LPL Financial. This is a hypothetical illustration. Individual results may vary. Opinions expressed in this article are those of Steven Higgins are not necessarily those of LPL Financial. All opinions are as of this date and are subject to change without notice. The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. There is an inverse relationship between interest rate movement and bond prices. Generally, when interest rates rise, bond prices fall and when interest rates fall, bond prices generally rise.