Tag Archives: interest rate

What Do People Do When Mortgage Payments Drop?

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I went to an interesting presentation today on a technical paper, Monetary Policy Pass-Through: Household Consumption and Voluntary Deleveraging. While the paper (by Marco Di Maggio, Amir Kermani & Rodney Ramcharan) itself is tough for the non-expert, it has some important implications that I discuss below. The abstract reads,

Do households benefit from expansionary monetary policy? We investigate how indebted households’ consumption and saving decisions are affected by anticipated changes in monthly interest payments. We focus on borrowers with adjustable rate mortgages originated between 2005 and 2007 featuring an automatic reset of the interest rate after five years. The monthly payment due from the average borrower falls by 52 percent ($900) upon reset, resulting in an increase in disposable income totaling tens of thousands of dollars over the remaining life of the mortgage. We uncover three patterns. First, the average household increases monthly car purchases by 40 percent ($150) upon reset. Second, this expansionary effect is attenuated by the borrowers’ voluntary deleveraging, as a significant fraction of the increased income is deployed to accelerate debt repayment. Third, the marginal propensity to consume is significantly higher for low income and underwater borrowers. To complement these household-level findings, we employ county-level data to provide evidence that consumption responded more to a reduction in short-term interest rates in counties with a larger fraction of adjustable rate mortgage debt. Our results shed light on the income channel of monetary policy as well as the role of debt rigidity in reducing the effectiveness of monetary policy. (1)

The paper cleverly exploits

the anticipated changes in monthly payments of borrowers with adjustable rate mortgages (ARMs) originated between 2005 and 2007, with a fixed interest rate for the first 5 years, which is automatically adjusted at the end of this initial period. These cohorts experience a sudden and substantial drop in the interest rates they pay upon reset, regardless of their financial position or credit worthiness and without refinancing. These cohorts are of particular interest because the interest rate reduction they experienced is sizeable: the ARMs originated in 2005 benefited from an average reduction of 3 percentage points in the reference interest rate in 2010. (3)

I will leave it to individual readers to work through how they designed this research project and move on to its implications:

The magnitude of the positive income shock for these households is large indeed: the monthly payment falls on average by $900 at the moment of the interest rate adjustment. Potentially, this could free up important resources for these indebted and mainly underwater households. We show that households increase their car purchase spending by more than $150 per month, equivalent to a 40 percent increase compared to the period immediately before the adjustment. Their monthly credit card balances also increase substantially, by almost $200 a month within the first year after the adjustment. Moreover, there is not any sign of intertemporal substitution or reversal within two years of the adjustment. . . . However, we also show that households use 15% of their increase in income to repay their debts faster, almost doubling the extent of this effort. (38-39)

There are all sorts of interesting implications that follow from this study, but I am particularly intrigued by its implications for “debt rigidity — the responsiveness of loan contracts to interest rate changes.” (6) While the authors are interested in how debt rigidity can impact monetary policy, I am interested in how it can impact households. There is much in the American housing finance system that keeps households from refinancing — high title insurance charges and other fees, for instance — but we do not often focus on the impact that rigid mortgage contracts have on the broader economy. This paper demonstrates that the effects are not borne by consumers alone. This paper quantifies the effects on the consumer economy to some extent and reveals that they are quite significant. Policy makers should take note of just how significant they can be.

Reiss on Low Interest Rates & Down Payments

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MainStreet quoted me in How to Get the Lowest Mortgage Rates Without a Large Down Payment. It reads in part,

Low mortgage rates can play a large factor whether homeowners are able to save tens of thousands of dollars in interest.

Even a 1% difference in the mortgage rate can save a homeowner $40,000 over 30 years for a mortgage valued at $200,000. Having a top-notch credit score plays a critical factor in determining what interest rate lenders will offer consumers, but other issues such as the amount of your down payment also impact it.

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Opt For an FHA or ARM

Both an adjustable rate mortgage (ARM) and a Federal Housing Administration (FHA) mortgage are good options if homeowners are concerned about receiving a lower interest rate and have not been able to accumulate the 20% standard down payment.

The biggest benefit of an ARM is that they have lower interest rates than the more common 30-year fixed rate mortgage. Many ARMs are called a 5/1 or 7/1, which means that they are fixed at the introductory interest rate for five or seven years and then readjust every year after that, said David Reiss, a law professor at Brooklyn Law School in N.Y. The new rate is based on an index, perhaps LIBOR, as well as a margin on top of that index.

While many homeowners gravitate toward a 30-year mortgage, younger owners “should seriously consider getting an ARM if they think that they might move sooner rather than later,” he said.

FHA loans can be a good option for consumers purchasing their first home because they require much smaller down payment of 3.5%.

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Given that young households tend not to have the savings for a substantial down payment, they can be an attractive option, Reiss said.

Reiss on Low Credit Scores and Mortgages

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MainStreet quoted me in A Low Credit Score Does Not Prevent You From Purchasing a Home. It reads in part,

While consumers who have low credit scores have fewer options to choose from, many can still qualify for a mortgage.

Lenders determine the mortgage rate based on a potential homeowner’s credit score, amount of down payment and how much debt he has compared to his current income.

What Your Credit Score Means

Credit scores play a large factor in the interest rate a borrower will receive because lenders are determining the likelihood of someone defaulting on a loan or missing payments, said Jason van den Brand, CEO of Lenda, a San Francisco-based online home mortgage service.

“It’s important to remember that the costs of a loan are closely associated to how ‘risky’ it is to give the loan,” he said. “If you look like a riskier borrower, your loan will cost more.”

Low mortgage rates can play a substantial factor in a homeowner’s ability to save tens of thousands of dollars in interest. Even a 1% difference in the mortgage rate can save a homeowner $40,000 over 30 years for a mortgage valued at $200,000.

*     *     *

Both an adjustable rate mortgage (ARM) or a Federal Housing Administration (FHA) mortgage are good options if homeowners are concerned about receiving a lower interest rate and have not been able to accumulate the standard 20% down payment.

The biggest benefit of ARMs is that they offer lower interest rates than the more common 30-year fixed rate mortgage and are good options for first-time homebuyers. Many ARMs are called a 5/1 or 7/1, which means that they are fixed at the introductory interest rate for five or seven years and then readjust every year after that, said David Reiss, a law professor at Brooklyn Law School.

FHA loans can be a good option, because they require a much smaller down payment of 3.5%.

*     *     *

Given that young households tend not to have the savings for a substantial down payment, FHA loans can be particularly attractive, Reiss said.

A Call to ARMs

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MainStreet.com quoted me in A Call to ARMs As Homeowners Opt for Lower Interest Rates. It opens,

Some homeowners are choosing adjustable rate mortgages instead of the traditional 30-year mortgages to take advantage of lower interest rates for several years.

The biggest benefit of an ARM is that they have lower interest rates than the more common 30-year fixed rate mortgage. Many ARMs are called a 5/1 or 7/1, which means that they are fixed at the introductory interest rate for five or seven years and then readjust every year after that, said David Reiss, a law professor at Brooklyn Law School. The new rate is based on an index, perhaps LIBOR, as well as a margin on top of that index.

The main disadvantage is that the rate is not fixed for as long as the interest rate of a 30-year fixed rate mortgage, but younger homeowners may not consider that a negative factor.

Younger Owners Should Consider ARMs

While many homeowners gravitate toward a 30-year mortgage, younger owners “should seriously consider getting an ARM if they think that they might move sooner rather than later,” he said. If you are single and buying a one-bedroom condo, it is likely you could enter into a long-term relationship and have kids.

The 30-year fixed mortgage rate is 3.50% as of April 7 while a 5/1 ARM is 2.83% as of April 7, according to Bankrate’s national survey of large lenders.

While ARMs expose the borrower to rising interest rates, they typically come with some protection. Interest rates often cannot rise more than a certain amount from year to year, and there is also typically a cap in the increase of interest rates over the life of the loan, said Reiss. During the height of the housing boom, lenders were originating 1/1 ARMs that reset after the first year, but now they reset frequently after the fifth and seventh year.

An ARM might have a two-point cap for one-year increases; that means, an introductory rate of 4% could only increase to 6% tops in the sixth year of a 5/1 ARM, Reiss said. That ARM might have a six-point cap over the life of the loan, which means a 4% introductory rate can go to no higher than 10% over the life of the loan.

Reiss on Being Financially Overextended

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US News & World Report quoted me in 5 Signs You’re Financially Overextended. It reads in part,

 Are you managing your debt? Or is it managing you? If you’re stuck in a money quicksand trap, you may not even realize at first that you’re in a financial predicament, especially if you’re sinking slowly and have been poorly managing your cash for a long time.

But if you suspect your debt is a disaster in the making, there’s no need to wait and see if your financial life will someday implode. If you’re pushing your finances to the limit, the signs are already there that you’re overextended. Just look for them. And if you spot one, don’t ignore it. Here are five of the biggest clues that trouble is coming.

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5. You’ve created opportunities that could make you overextended. If you have a lot credit cards or lines of credit you rarely use, you could, in theory, end up spending a lot of money and getting yourself into trouble that way, but having those lines open isn’t itself a bad sign. It’s a sign that you have good credit, and your creditors trust you. Still, it’s good to remember that if you aren’t monitoring yourself, you could ultimately max out and find yourself buried in credit card debt.

At least in that scenario, you have control over what may or may not happen. Some homeowners, however, put themselves at risk for becoming overextended when they get an adjustable rate mortgage or a home equity line of credit in which the interest rate “may float with some kind of index like the prime rate or [London Interbank Offered Rate],” says David Reiss, professor of law and research director at the Center for Urban Business Entrepreneurship at Brooklyn Law School in Brooklyn, New York.

“So if interest rates rise dramatically, the home equity line of credit can become unaffordable,” he says. “Interest rates have been very low for some time, so homeowners are not focusing on this risk, but if they were to rise – and they can rise suddenly – homeowners may face a rude awakening.”

In which case, you may want to refinance and position yourself to avoid becoming financially overextended if the interest rates someday jump. Because what happens to anything when it’s stretched beyond its limits? It – or you – will snap.

Salary Needed for a House in 27 Cities

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HSH.com has posted a study to answer the question — How much salary do you need to earn in order to afford the principal, interest, taxes and insurance payments on a median-priced home in your metro area? The study opens,

HSH.com took the National Association of Realtors’ fourth-quarter data for median-home prices and HSH.com’s fourth-quarter average interest rate for 30-year, fixed-rate mortgages to determine how much of your salary it would take to afford the base cost of owning a home — the principal, interest, taxes and insurance — in 27 metro areas.

We used standard 28 percent “front-end” debt ratios and a 20 percent down payment subtracted from the NAR’s median-home-price data to arrive at our figures. We’ve incorporated available information on property taxes and homeowner’s insurance costs to more accurately reflect the income needed in a given market. Read more about the methodology and inputs on the final slide of this slideshow.

The theme during the fourth quarter was increased affordability.

Home prices declined from the third to the fourth quarter in all of the metro areas on our list but one. But on a year-over-year basis, home prices have continued to trend upward.

“Home prices in metro areas throughout the country continue to show solid price growth, up 25 percent over the past three years on average,” said Lawrence Yun, NAR chief economist.

Along with affordable home prices, mortgage rates fell across the board which caused the required salaries for our metro areas to decline (again, except for one).

“Low interest rates helped preserve affordability last quarter, but it’ll take stronger income gains and more housing supply to help meet the pent-up demand for buying,” said Yun.

On a national scale, with 20 percent down, a buyer would need to earn a salary of $48,603.82 to afford the median-priced home. However, it’s possible to buy a home with less than a 20 percent down payment. Of course, the larger loan amount when financing 90 percent of the property price, plus the need for Private Mortgage Insurance (PMI), raises the income needed considerably. In the national example above, a purchase of a median-priced home with only 10 percent down (and including the cost of PMI) increases the income needed to $56,140.44 – just over $7,500 more.

This sounds like a pretty reasonable methodology, but there are a lot of assumptions built into the ultimate conclusions. They are generally conservative assumptions — buyers will get a 30 year fixed rate mortgage instead of an ARM, buyers will have 28% debt ratios. I would have liked to see some accounting for location affordability, because transportation costs can vary quite a bit among metro areas, but you can’t have everything.

As always, I am particularly interested in NYC, the 24th most expensive of the 27 cities.  NYC requires an income of $87,535.60 to buy a median home for  $390,000. By way of of contrast, the cheapest metro is Pittsburgh, which requires an income of $31,716.32 to buy a median home for $135,000 and the most expensive was San Francisco, which requires an income of $142,448.33 to buy a median home for $742,900.

S&P on Jumbos

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Last week, I discussed an up beat S&P report on the overall RMBS market. Today I discuss and S&P report on the jumbo mortgage market. This report sees much slower growth in the private-label jumbo residential mortgage-backed securities market. It opens,

U.S. housing has been recovering, and residential mortgage collateral performance continues to improve, a trend that we expect to continue in 2015. However, housing finance still faces challenges and relies on government support. Private capital has been slow to reenter the residential mortgage market, and nonagency securitization volume remains relatively small, with diversity and growth mostly coming from nontraditional transactions in recent years. Standard & Poor’s Ratings Services believes nonagency securitization—-utilizing private capital–could be a key contributor to a more healthy housing finance market while limiting risk to taxpayers.

A revival in the U.S. nonagency residential mortgage-backed securities (RMBS) market has not followed measured recoveries in the broader economy, employment, and housing. RMBS not guaranteed by one of the government-sponsored enterprises (GSEs)–such as Fannie Mae or Freddie Mac–hit a high of $1.2 trillion in 2006, but we expect that figure to be near $50 billion in 2015, up approximately $12 billion from 2014. Clearly, even with the ongoing recoveries in the overall economy and housing market, nonagency U.S. RMBS-related issuance remains negligible in the $10 trillion housing finance market.

We believe the slow pace of non-agency securitization reflects a market still grappling with the changing economics of complying with new regulations, a lack of standardization in nonagency securitization provisions, anticipated interest rate hikes in mid-2015, and a cautious investor base in newly originated nonagency RMBS. Considerable clarity has emerged regarding new regulations this year, but other limiting factors persist.

Hopefully, S&P has correct identified the cause of the slow growth in this sector. But we need to be vigilant to ensure that there is not a more fundamental problem with the jumbo private-label MBS market. it is vital that this sector of the market develops in order to provide a private capital alternative to the existing market which depends to a very large extent on government guarantees.