Checkmate

A recent article from my friend Greg McNey of American Signature Mortgage. Quite apropos given this weekend's news of the federal government's involvement in reassuring consumers of Fannie Mae and Freddie Mac.

Checkmate

A stalemate is unfolding in the local real estate market as sellers, determined to stand by their prices, line up opposite buyers, emboldened to wait patiently for values to fall further. But, while each waits for the other to blink, the threat of an increase in mortgage interest rates could change the rules of the game.

Two dynamics present in the current market, record low interest rates and falling home prices, are not commonly found together. Many believe it was historically low interest rates that helped drive housing prices higher between 2003 and early 2007. Lower interest rates meant that buyers could strengthen their buying power, purchasing more house for the same monthly payment.

However, since the middle of 2007, when buyers left the market and inventory levels rose, prices have retreated. Yet, interest rates remain in the first quarter of 2008 at the same levels they were during the first quarter of 2007. This is an unusual combination of circumstances that shouldn’t be expected to last indefinitely.
While lenders are reluctant to cool the market further, they are also finding it more difficult to secure funds to lend, and with decreasing supply comes increased pricing. Additionally, lenders are returning more and more to risk-based pricing where interest rates are determined not only by the time value of money but by the lender’s perception of the likelihood of the borrower’s default.

While major jumps in mortgage rates don’t appear imminent, even the prospect of an increase is something that should step up the negotiation between sellers and buyers. Here’s why:

How much home a buyer can afford is as much a function of the monthly payment as it is the actual purchase price since most purchases are made based on what the buyer can afford each month. If the amount of that monthly payment is a constant, then the buyer and seller are both motivated to complete a transaction before interest rates increase. A rise in rates reduces how much of that monthly payment can be allocated to principal, thereby reducing the purchase price a buyer can afford.

For example, let’s assume you intend to buy a home with a 20% down payment and plan to finance the balance with a 30 year fixed-rate mortgage. If your household can afford a monthly principal and interest payment of approximately $1,500, you should be able to purchase a home priced at $312,500. However, if the interest rate increases to 7%, you would have to purchase a home priced at $281,500 to maintain that same $1,500 monthly principal and interest payment. That’s a $31,000 and more than 10% decrease in the value of the home you can afford.

So, who will make the first move? Time will tell, but each player has a reason to act sooner rather than later to get a deal done.

Buyers, since home prices have already taken a hit, you must assess the risk of waiting for another significant drop. Even a 5% decrease in prices may not be enough to offset the affect of financing your purchase at a higher interest rate.

And, sellers, if it has been tough to find a buyer during the last few months, imagine your difficulties if the buying power of the customer base should erode.

The bottom line is, while buyers wait on sellers and sellers wait on buyers, interest rates may step in and force the discussion, but at a cost to everyone involved.