These artificially low interest rates may come back to haunt us. The Fed is artificially holding rates down at historic lows. This may seem good for the housing market, but will we pay the price later?
Peter Schiff, EuroPacific Capital CEO, has been sounding this warning bell for quite some time. Just like he had done in 2006 and 2007 warning about the pending housing crash, his warnings fell on deaf ears. He has my attention this time around..
“In America, the problem is that interest rates are too low.
They have to go up. We can’t have an economy with interest rates at zero. If the Fed lets interest rates go up, we have to realize that we will have a deeper recession, we have to realize that banks are going to fail.”
America is an economy that is based on borrowing for consumption and borrowing to sustain a massive government that is spending a tremendous amount of money.”
“The reason that all the pieces haven’t collapsed already is because interest rates are very low and they are low because the risk is not properly perceived.”
There are stories out there that housing affordability is going down because of limited supply of homes. I believe this is focusing on the wrong problem. The big problem is artificially low interest rates driving prices up which is great in the very short term, but what happens as interest rates go back to where they should be? Or what happens if the interest rates skyrocket in order for the market corrects itself?
I played around with NAR’s Housing Affordability Index Model. Using the Index’s formula and keeping Median Income and Median Home Price at June 2012’s level, I began to change the interest rates.
An HAI of 120 means the Median Household Income has 120% of income required to purchase the Median Priced home.
The calculation assumes a down payment of 20 percent of the home price and it assumes a qualifying ratio of 25 percent. That means the monthly P&I payment cannot exceed 25 percent of a the median family monthly income.
June 2012, the HAI is at 178.4% with a Median Income of $61,061, Median Home Price of $190,100 with Interest Rate at 3.8%.
By increasing the interest rate to 5%, the HAI drops 23.5% to 155.9. The percentage drop goes down as interest rates rise (see charts below).
Since the Index can not go below 100, because that is 100% of the income to qualify for the median home price – the median price must change. In a real market scenario, the median price would begin to drop before the index reaches 100, I would guess that is around the 120-140 range on the index.
The Index “breaks” between 9% and 10% interest rates. From there I calculated where the median price would be close to 100 on the index.
So the question remains – What would interest rates be without Fed messing with the market?
I believe the housing market could handle 6% – 7% interest rates. If interest rates were to “over-correct” or skyrocket to 10% to 14%, we could be looking at up to another 30% drop in home values.
If you think 10% to 14% interest rates are impossible, just look back to 1981 when rates hit 18.45%. If you are old enough to remember, the Fed was fighting runaway inflation. (read more about Paul Volker’s policy).
What is your take on this? Are we working ourselves into another housing bubble or this projecting to many what-if’s?