Do Lower Interest Rates for Mortgages Today Make Them Cheaper?
How tiny numbers are manipulating the bigger picture
Interest rates are at historic lows. That’s what your real estate agent is telling you to entice you into that new house you have had your eye on. It’s 16% more expensive than it was at the beginning of the year, and the real estate market doesn’t seem to be slowing down.
With interest rates below 3%, most people believe that they’re getting a house for free. At least, that’s what the small interest rate is signaling. While the interest rate has been consistently falling for the last 40 years, home prices have been doing the exact opposite.
It doesn’t matter how low of an interest rate you are getting for that new house. Or, maybe it does, you’d think. Here’s a better question:
What does the interest rate mean, exactly?
Most people will be shocked to understand that the majority of their payments for the first half of the life of a 30-year mortgage go toward interest. In fact, it’s not uncommon to see that interest, insurance, property tax, and maintenance of the home will occupy upwards of 80% of the payments for the first half of the mortgage’s life.
Consider a home today valued at $340,000, with 10% down, at 30 years, with 3% interest.
By year 17, the mortgagee will have paid approximately $123,000 in interest and a tad bit more in principal. If we also include the monthly insurance and the tax for that length of time, we will add $61,200. That will be a sum total of $184,200 for insurance, tax, and insurance.
As a comparison, let’s take a home in 1995, using the chart by FRED above. A prospective homebuyer is looking at a $120,000 house on an 8% interest rate — fixed over 30 years.
At first glance, this second example seems worse. In the same period, there has been about $130,000 in interest paid and $31,293 in principal.
The wages from 1995 to present have not followed the proportion of increase in homes. While wages have doubled in that time frame, the median home price has tripled.
Even though the interest rate has dropped considerably, that drop does not make a home today more financeable to the average American. In fact, in 2008, we saw the eventual calamity of accelerated home transactions to buyers who didn’t have the realistic means to afford them.
The amount of homeowner’s equity lost in that small sliver of time amounted to about $8 trillion. This wasn’t a small mistake in the chronological timetable; it was a colossal effort to overcharge a market for no other reason than to make a commission on accelerated transactions. It took the United States until 2002 just to accumulate $8 trillion in homeowner equity. It lost that much in just two years.
The middle class has almost all of its net worth tied to their home. In many ways, this is a good thing; the home is eventually paid off and slowly becomes an asset. It is earned over time. When the asset class is overtransacted due to artificially plummeting interest rates, it yields a skyrocketing effect that seems unreal.
It isn’t just the homeowner's equity that’s increasing over this span of time. Mortgage debt has increased almost linearly alongside it. Except, mortgage debt is real — it stays stagnant the entire time. Homeowner equity is something that can change with a home’s price. This rings wholly true when a home’s price begins to come down, too. At that point, the debt remains whereas the asset deflates to hit a realistic valuation.
That equity may diminish, your debt won’t.
Homeowner’s equity has almost tripled since the bottom in 2012. From a figure of $8.4 trillion, we have now eclipsed $20 trillion in eight short years.
Even if we look at GDP per capita in the United States, we can’t justify the rapid increase.
Every now and again, valuations seem to derail from the path of sustainability. Whether that’s in equities on the stock market or homes in real estate, supercharging occurs.
Lower interest rates would be beneficial in an economic environment where the average person was earning, in real dollars, higher wages in proportion to the increase in home prices. This hasn’t happened. In fact, wages have fallen with respect to the cost of most things, and, especially, with the median home value. While a lower interest rate seems appealing today, since interest is paid forward, you still end up paying a larger portion of your wages into the total cost of the home.
If we were to calculate “true net worth” of an individual; that is, the value of an individual’s assets minus the supercharged appreciation for homes in the last eight years, we would actually see a dampened figure. This is because most of the net worth is created in that appreciation and not in the original equity-building of the home. Say, for instance, the homeowner defaults on a home they refinanced, and then the home loses value, the bank will force the homeowner into a quick sell or a foreclosure and eat into any tiny equity built (if any). This is because majority of the payments made were in interest, and then the idea of the refinance was to bet on future rapid appreciation in the home’s value. If that doesn’t happen, the asset collapses to its former value, and the bank forces a sale of the home at a depressed valuation.
No matter how low the interest rate falls, interest is always paid first and amortizes over the length of the mortgage. Whether that is on a $500,000 mortgage or a $200,000 one, the concept of that interest decay remains the same.
In the past, when the mortgage industry made a mistake, the taxpayer bailed them out. In the present day, the Federal Reserve decided to print money against itself. Furthermore, the interest rate is as low as it can go.
Eventually, the amount of back-up options on mistakes runs to zero. If we haven’t already converged to that level, we’re running awfully close to a place with no choices. Especially when valuations make little sense and financing has become a marketing gimmick to charm prospective mortgagees.