Interest Rate Jumps; Unfortunate, but not Catastrophic

I'll be writing on this quite a bit, and I'll start off by saying that, as regular readers know, I do NOT think recent interest rate jumps are the end of the world. I'll get to why in a bit, but first, a recap.

Last week, large mortgage lender American Home Mortgage shut its doors. That made the markets very panicky and led to an increase in rates for two specific loan types: "Jumbo" and 2nd trusts.

"Jumbo" loans are loans above $417,000--the limit for "conventional" loans set by Fannie and Freddie, who buy mortgage loans from originators. Fannie and Freddie exist to create a “secondary market” for mortgages—that is, they buy loans for cash, and then originators use that cash to make more loans to homebuyers. If they didn’t exist, then banks would only be able to loan as much cash as they had on hand, and would have to hold the mortgages until each homebuyer sold or paid it off. (That’s a bit of an over-simplification, but for our purposes it should suffice.) Fannie and Freddie are government “sponsored” (though not technically government-insured), and so the loans they can buy have certain restrictions, i.e., are under $417K. Because there’s an easily available secondary market for this size loans, they typically have a lower interest rate than the larger, or “jumbo” loans.

Now, $417K doesn’t buy you much in this area, so lots of people end up with “jumbo” loans. And since even the smallest place is usually in the $300s, many people in this area don’t put 20% (or about $60K+) down. That hasn’t been an issue until now. You can put 5% down, take out two “trusts” (or loans)—one for 80% and one for 15%, and be on with your home purchase. Those second trusts are becoming an issue, though. Read on:

The second impact of this panic is a big jump on the 2nd trust rates. 2nd trusts have always been riskier for lenders—they’re junior liens, after all, and so carried a higher interest rate. But that rate is the other important change in the past week. It jumped significantly.

Two impacts on this market are clear, but in my opinion, neither is catastrophic. At least not yet.

1) For most buyers, they can afford less. So if you were shopping at the top of your affordability range, chances are you can no longer afford that payment, regardless of how much you were putting as a down-payment. How much less? We’ll have to see where the rates stop. According to the Post, rates are up almost a full percentage point since May. So for every $10,000 borrowed, that’s $100/year.

Let’s use an example. Let’s say a buyer was looking at in the $600,000 range starting in May. Rates jumped up a point since then. That means that if there is NO room in their monthly budget (and why would any responsible person be looking at that price if there was absolutely no room in their budget?!) then now they can only afford $500,000. Another way to say it is that having the same $600,000 mortgage now costs them an extra $6000/year (which, making some assumptions about income bracket, is about $4000/year out of pocket after taxes.)

My guess—and I certainly could be wrong—is that people shopping for $600,000 homes have just a little bit of wiggle room in their budgets, maybe even up to $4,000/year. I think most people in that income and affordability bracket will make the trade-off, see their home as an important investment, and forgo a few discretionary items to get the house that they still want. I believe that the majority of the people are NOT going to change the range in which they’re looking, at least not by much. Again, maybe I'm naive, or maybe I'm just lucky that my clients tend to be responsible purchasers (or, not to pat myself on the back too much, but maybe I do a good job counseling them up front and introducing them to reputable lenders who counsel them too).

In my experience, the people who tend to stretch their budgets to the breaking point are the people who are buying their first place, which is often under $417K, and therefore not impacted by the jumbo rate jump. They are, however impacted in another way. They usually have less of a down-payment (because they’re not rolling over equity from a previous home), and are borrowing more than 80% of the purchase price.

2) For all borrowers planning to finance more than 80% of the purchase, you can afford less. This one worries me less—one, because only 15% of the loan is going to have a significant jump in rate, and that’s a whole lot better than having it hit the 80%. Second, there exists an option to borrow 95% as one trust and pay PMI. PMI, which historically was a dirty word for borrowers, is more acceptable now because in 2007 it’s tax deductible, same as interest. Boy, did they pick a good year to change that rule! So the 95% trust, as long as it’s not jumbo (see impact #1) should keep the payment roughly what a borrower was planning two weeks ago.

I’m sure this will continue to be a front-page crises for a few weeks. I’ll write more as the situation evolves. But I still stand firm in my conviction that if you are:

- Financially able to buy: good credit, a reasonable budget, about 8% of the purchase price in savings, and
- Your life situation calls for buying instead of renting: will be in this area for 3 or more years, you have reasonable expectations of what you get for the money, and you recognize that even a flat return on an investment is better than rapidly increasing rents (see Rent vs Buy calculator post),

Then this is still a good time to seriously consider buying.