Why Home Buyers Win When Rates Spike

In the recent boom years, Summer and Fall were the best of times for home sales. Even in Summer 2005, one full year after the Fed started raising rates off of all-time lows, huge sales volume helped both sellers and buyers win. It wasn’t until Fall 2006, and especially this year, that we saw a shift.

And quite a shift it’s been. The National Association of Realtors (NAR) reported in late-June that existing home sales volume slumped to a four-year low, and nationwide median prices were down 2.1% versus a year earlier. This came after the sharpest short-term rate spike in almost five years, and set the tone for what we’ve seen since.

Now, as we head into Fall, it’s important for buyers to understand that higher rates mean less demand and therefore lower purchase prices. It’s more financially beneficial to pay less for a home in a higher rate environment and refinance later than it is to wait for lower rates. Because when rates drop again, higher demand pushes up home prices.

Low Prices Better Than Low Rates
Let’s examine what current market conditions mean if you’re considering a $600,000 home purchase today versus one year ago. We know that year-over-year home prices declined 2.1%, so this same home would have cost $612,870 last year. We also know that a 30-year fixed rate is 6.75% at press time this year, which is .25% higher than last year.

With 20% down on $612,780 and a 6.5% rate last year, your monthly mortgage interest would be $2656. With 20% down on $600,000 and a 6.75% rate this year, your interest would be $2700. This year’s higher rate means $528 more per year. But the $12,870 you’re saving in purchase price far outweighs the $528 in extra interest cost.

Taking this example one more step, let’s say rates drop .25% next year and you refi the loan on your $600,000 purchase, reducing your monthly interest to $2600. Versus buying last year, this saves you $672 per year in interest (and $12,780 in purchase price). In the worst case, it would cost $2800 to refinance this loan. The refi saves you $100 per month versus your purchase loan, so it would take 2 years and 4 months to break even on refi costs. This is a normal breakeven period for any refi, and in this case, saves you $33,200 over the remaining 27.6 years of the loan.

Where Are Rates Headed?
Now that we’ve seen how buyers can win with lower prices when rates rise, the question is: are there any refi opportunities coming? Day to day, mortgage prices are based on mortgage bond yields. But to get a broader perspective on overall rate market movement at a certain interval in the economic cycle, we can also look at yields on the 10-year Treasury note.

The Treasury yield’s low point for 2007 was 4.49% on March 13. It rose .76% to 5.25% by June 12, and has backed off to the 5.10% range since then. This steep rate upswing reflects a rapid change in the outlook for the economy and interest rates. Previously, the market was betting a weak housing sector would slow the economy and cause the Fed to stimulate growth with a rate cut. But this Summer, strong corporate earnings, job/wage growth and manufacturing caused Treasury (and mortgage bond) investors to worry that the Fed might actually hike rates to moderate growth and inflation.

The Fed is justifiably cautious on inflation, but a Fed hike seems unlikely with sustained housing weakness pressuring consumers, who account for two-thirds of economic activity. Higher monthly costs forcing more price declines may be on tap for consumers as approximately $1.2 trillion of ARMs adjust as much as 2% upward between now and December 2008.

This quick rate outlook plus a method for analyzing buying opportunities provides a way to help buyers navigate this market. As you can see, the math generally supports buying low when rates rise. Refinancing into a lower rate later on is just a bonus. From here, you just need to work with your mortgage advisor to apply this methodology to your own financial profile and your local market. Even if you elect to sit out for awhile, this will help you understand your options as you watch the market.