June 14, 2007

You Want Mortgage Rates? You Can’t Handle the Rates! Why Rates only Matter to Over Leveraged Owners and Banks: A Few Good Mortgages

In a land far, far away rests a place where homes are bought with 20% down and mortgage rates hover around 8%. In this world, we also have moderate credit growth and a government making a decent effort at decreasing budget deficits. In this mythical world, people try an antiquated concept of spending less than they earn. Welcome to the world of the Financially Prudent.

Somehow in the last few years, we’ve had this mortgage rate fixation that seems to be the dominating tour de force in all things economic. If Ben Bernanke hints at a rate decrease the markets get all excited and stocks go up like hot air balloons in Napa Valley. And when rates spike, the market gets hammered. For all this rhetoric about housing being a small sliver of the economy, it sure makes a big impact when Ben sneezes and it infects the entire stock market which theoretically, is a sample size of the American economy.

We are still at record low mortgage rates. Take a look at the historical 30 year mortgage:

Somehow the threat of a .25 increase sends the market into a tornado of dark mysterious destruction. But what does this truly say about our economy? What it implies is that we are codependent on low rates to sustain the economic growth we’ve experienced. What it also implies is our addiction to credit. When rates increase the money supply contracts and this leads to scarcer credit. In addition, with record low savings rate and the imprudent approach to the down payment, you can now finance your entire home purchase and even get cash back. Cash back you say? It may be a little harder to do this now given market sentiment but this was commonplace just a few years ago. In fact, we had loans with 125% loan-to-value ratios. Buy a house and get $50,000 in your pocket. No wonder why we are enjoying a 70% record home ownership rate. There is one small and infinitesimal caveat, you need to pay the money back! Somehow folks felt that they bolted on a silver Diebold ATM to the side of their house and any equity in the palace was earmarked for vacations, remodels, paying higher credit card debt, or buying a car. Otherwise the home was ground zero for our consumption economy and has kept it afloat after the 9/11 attacks.

Let us take a look at another chart, the Fed rate chart:

As you can see from above, we nearly went to zero percent in 2003. Think about what this means. Banks have fractional reserves with the Fed banks. The lower the Fed rate, the more they can borrow and lend out. Since fractional reserve banking isn’t one-2-one, any drop in rates means an exponential growth in the money supply. And with lax underwriting standards and the foreign debt appetite, we were able to finance nearly anything in our economy. There are many dense economic books talking about monetary policy but suffice it to say that anything below 3% for all intents is viewed by and large as free money. We hovered below 3% for 3 years! It was like an orgy of credit; images of Scrooge swimming in gold coins and $100 green bills come to mind.

Yet we forgot one thing in all this free money. Rates only encourage spending or stifle spending. Sound economic policy is based on monitoring credit expansion. Of course asking the wolves to mind the hen house isn’t the smartest thing, this is the policy we have been following since the start of the millennium. But for consumers, rates do not matter. The first thing you learn in real estate investing is location, location, location. Okay, lesson one is finished. But the second paramount thing to understand is you become successful by the purchase price of the home.

Rates Do Not Matter!

This fixation on the monthly payment I’m starting to find is based in behavioral economics and psychology. Everything is boiled down to the monthly payment.

“ReplayTV for only $39.99 a month!”

“Cell phone family plans for only $69.99 a month!”
“Enjoy credit protection for $19.99 a month.”
“Your interest-only payment for $1,600 a month.”

Sound familiar? When was the last time you heard an ad for “cell phone family plans for $840 a year?” How do you eat an elephant? One bite at a time. How do you bamboozle the public? Apparently by breaking everything down to the monthly payment.

Ironically this only works with spending and not savings. Why not save this much a month in your 401(K)? Why not sock away 10% a month for 30 years and be a millionaire like every self-help financial books discusses? Psychologically spending and saving are processed differently. They are diametrically opposed. If you spend $5 you cannot save that same $5. Marketing companies have honed into this message and have it down to a science. But again, the monthly amount does not matter, it is the price of the item.

Let us take a look at two scenarios for a home. We’ll use two different scenarios to point this out.

Scenario 1

Los Angeles Home

$500,000 Purchase Price

20% Down = $100,000

Current Rate and Terms: 6%

Monthly Payment (taxes, insurance, principle) = $2,820

Scenario 2

Los Angeles Home (20% Drop)

$400,000 Purchase Price

20% Down = $80,000

Future Rate and Terms: 8% (closer to historical average)

Monthly Payment (taxes, insurance, principle) = $2,680

So not only do you save $20,000 on your down payment but you are also saving $140 a month on your payment. The above scenario is very likely. The reason I highlight this is because many lenders and brokers are trying to scare clients about the boogie man of interest rates. Give me a cheaper house with a higher interest rate any time. You want higher mortgage rates? You can’t handle higher rates! So the mortgage industry would like you to believe.

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Anonymous said...

Dr. Hobub,

I love reading your blog. Absolutely the most relevant information to a wannabe home purchaser in SoCal. My wife and I have quite a large sum of money and would like to buy a house in Monrovia (when prices get back in line with fundamentals)...a friend of ours says don't sink our nest egg into the house; put a traditional 20% down and let the remainder earn interest which will cover higher monthy nut and then some. Care to comment? THANK YOU.

bitterLArenter said...

You made it as clear as day. How much do you want to bet the majority of FB that purchased in the last few years have never seen info like this? Thank you, Dr!

Anonymous said...

Fantastic article, Dr. I'm a bit separated from the majority mentality, but you're right-on-the-money with the 'payment mentality'. Affordability through monthly payments is the KEY to fleecing people.

After 18 years with the same car, I recently had to purchase a new one. The sales pitch was totally geared toward 'lowest monthly payment possible.' I sat there thinking that this tactic probably works with most people, allowing them to squeeze more out of each customer. In the end, I chose $11K down, 2-years of financing, with no extras, which was easily affordable. I was asked, "How did I come up with $X/mo as a payment?" I wanted to say, I can add, subtract, and multiply--DUH!

No, I don't own a home, but my 'tactics' would be the same.

Debbie said...

What a beautiful article with clear and concise points.

Back in 2001, my husband and I moved to Las Vegas and knew we would only be there for 3 to 4 years. we had 70k saved and looked into buying a house. We didn't buy. In hindsight, we could have made a killing, I guess... but our thinking at the time was quite sober. Our thoughts? Rent was cheaper for a big house in a better part of town. And what if Murphy's Law were to occur... what if we somehow got a lemon that needed expensive repairs? What if we couldn't sell in our timeframe? Did we really want to be long distance landlords? And finally, we knew that owning a home meant we would be more likly to blow money on little improvements. I guess, this can be seen as being too cautious. But owning a home, taking on that much debt, we believe, is not a descision to be taken lightly.

One more thing... during that time, arounnd 2003, a young couple bought the house next door. They were teachers and I assume made together 80k or less yearly. They bought the house, a new truck, a new car, remodeled the driveway, and put in a pool. Maybe they had hidden savings. But I remember thinking how in the heck could they afford this?!? When we left, the other neighbors all expressed interest in learning who our landlords were, so they could attempt to buy our house - as an investment. They were all paycheck to paycheck types. I didn't know about no money down or liar loans. Or interest only. I just couldn't believe it was possible to do what they were attempting.

I think a lot of my old friends in Las Vegas are in trouble now.

My husband and I? We are not trying to be like Trump. Isn't that ok? Does that make us chumps?

It's just that we value the freedom of a paid off car and no credit card debt. In fact, I get a little high off of paying my card in full, on time, and getting cash back from those leeches ;)

Thanks for letting me add these comments to your awesome site. -Debbie

Kevin said...

Dr. H,

I think the bond traders will push mortgage rates to 7% by year end. Also if you purchase at a lower price and higher rate you can always refi in the future. If you purchase at a higher price and a lower rate, you can't refi and you will most likely have to sell for less than you bought if rates go up. I'm hoping for the highest rate possible as it wont hurt me as I'm going to buy it cash.

Anonymous said...

I love this post! My wife and I are living frugal (not cheap) and we are surrounded by wannabe spenders who all think they are Paris Hilton. No 401k, no reserves, no nothing. They are all house debtors and full of air. $300 jeans, Gucci glasses and so on. It is difficult to live in this environment because nobody understands that sometimes we are not willing to go to dinner with friends because I can buy groceries for a week with the money I spend for 1 dinner. People think we are cheap or don't get it but we are on our way to our first million, constantly stashing money in 401k's, IRA's, Money Markets and such. We will not wafer from our ways but it gets old real fast if your surrounded by these morons who have not a pot to piss in and have no clue when I talk about saving, investing, compounding. What really irks me that in the future we have to bail these idiots out with higher taxes WE have to pay and of course since we have investment income we are considered “RICH” and that needs to be penalized. I hate politicians who always talk about taxing the “RICH”, meaning taxing us who didn't live above our means, stashing “OUR” money away and maybe take a vacation every 4 years. Disgusting!!!!

socalwatcher said...

I am usually somewhat ashamed to admit that I sold cars for about 2 1/2 years. I learned alot, though and not about cars. I saw peoples credit reports and finances. In the area I was in, I saw ALOT of cars paid for in cash with checks from lending houses from HELOC's. Even when they could have just used traditional financing through the manufacturer to get a 1.9% rate which is cheaper, they usually refused. "It's not tax deducatable!". Well genius, by the time you write it off you are close to the mfr's rate and you have not leveraged your HOME to buy a depreciating liability!!

There is a worksheet used by most dealers called a "Four Square". One square is for monthly payments. The most money is made on people who cannot use a calculator to add:

$xxx per month X's length of the loan= ultimate price of the car.

They do not care what the price of the car is, they just look at the monthly nut. Same goes with things like adding a set of $5,000 24" rims. Just finance it and the rims only cost $xx/mo.

Same goes with housing. The people who mostly got whacked by these lenders who make car sales people look like saints look at monthly.

Mr Vincent said...

From post #1:
"a friend of ours says don't sink our nest egg into the house; put a traditional 20% down and let the remainder earn interest which will cover higher monthy nut and then some. Care to comment? "

My Opinion:
If I assume you are still working. I think your friend is correct. Put down 20% and get a 15 or 30 yr FIXED rate mortgage.

Keep your other money in the bank earning interest and pay off the place if/when you decide that this is the place where you plan on staying in after retirement.

I know the Monrovia area well. It has an old town feeling to it. I lived there for a few years when I was a kid after we moved to Cali.

In the 1980s I was there quite a bit due to the large GTE training center that was there near Myrtle ave.

The north part of town has some great older homes, but I hear that alot of teardowns have occurred and replaced mith McMansions.

Anonymous said...


You just revealed my stratagy. Thanks a lot!!

Anonymous said...

Great post Dr. HB!

Dont forget that with the 400K w/ 8% you also owe 80K less than the 500K w/ 6% in addition to the payment being lower $140 a month and "saving" 20K on the downpayment.

Anon 1129
I know exactly what you mean. When I bought my first new car I financed. I was a payment shopper back then and wanted a particular payment. I remember the sales person arguing that "its only $40 a month more." I looked at him and said...that is almost a $2500 difference. He said "no its not"! What a moron! I had to ask him to take out his calculator and verify... he was stunned and just felt stupid. Like some of you guys said I just knew how to do simple math.

anon 818
I also feel your pain. My wife and I make a comfortable living. We both teach. My friends and family dont understand why it is that we dont "enjoy" our money. We dont dress in designer clothing or finance fancy cars. Both our cars are paid off and have no CC debt. What I tell them is that I dont work more than 7 hrs a day I get roughly about 3 months off during the year including every holiday. I value my time much more than I value my money. I tell them that its not how much to you make but how much you keep at the end of the month that matters. Not only that but what you do to make that money. But hey...to each his own.

Don said...

re post #1, I can think of really only two reasons to pay more than 20% down:
(1) To bring the housing payment down to an affordable range for you. Make sure that you're taking into account property taxes and HOA in that monthly payment so that you don't go over 28%.
(2) To bring your mortgage down from being a jumbo mortgage to a standard (you'll save around a quarter percent).

But as a former home owner, I would say that it is important to have a cash reserve to cover unexpected costs (and there will be unexpected costs) as well as a cushion in case your employment goes south (figure at least three months' salary).

socalwatcher said...

Don, you forgot a third reason:

Avoid PMI.

Anonymous said...

34% drop in SoCal home sales. The shoe is dropping as Dr. HB has stated over and again. Prices still up, but that's due to the pukey Hollywood rich tossing 3 or 4 million at a place, while all those 400k Houses of Genius or cookie-cutter "developments" sit and sit and sit. Actually, good riddance to all the crackerjack McMansion builders. Bye bye Pulte.

Schahrzad Berkland said...

In the 1980's, sellers carried financing for their buyers, because interest rates were so high.

If rates go to 15% again, yikes!

Here's my story on the impact of higher rates on housing

The era of lower rates is over. Cheap rates are causing inflation.

SmashMonster said...

Great article! I always hear, "People could afford these houses because the interest rates were so low." Sheesh - I don't care how low the interest rate is if you make 100K a year you can't afford a typical SoCal home without some kind of toxic loan and absurd debt. Whatever happened to planning for the future? Whatever happened to save for a rainy day?

Propaganda can definitely move many people to make decisions that are not in their best interest!

The old why-rent-when-you-can-get-a-tax-benefit-with-a-mortgage argument grew tired years ago when the savings in taxes was far less than what I could save by renting.

Thanks for such a great blog! I've noticed a lot of the bubble bloggers have stopped or slowed down on posting and I am so glad you are still writing.

bhale@colorado.edu said...

Hey Schahrzahd: No fair hiding your article behind a subscriber wall! I'm in Colorado with no interest in the California market. I just want to read your article. Can you at least summarize?

Working Class Schlep said...

Excellent post.

LIBubble said...

Great article! I'd like to add to it.

Sheeple are highly attracted to the monthly payment; especially the ones that were renting previously since they are used to paying by the month. With their toxic loans at 3% for 2 or 3 years; the monthly payment seems logical to them along with the myth that they are building positive equity instead of "throwing their money away on rent".

Dr Housing Bubble said...

@anon 10:35,

You are doing the right thing. Shortly after your post, the stats for Southern California came out. Guess what? Sales got hammered and as we predicted, median prices jumped. Again this is because higher priced homes are still moving while lower and middle priced homes are stagnant. Save up until summer of 2008 and reevaluate at that time. No point jumping in at the peak right?


There was a comment how some bloggers are cutting back on their post. My guess is that many are seeing the mainstream media pick up the slack now. However, I’m not pleased with the articles because they always start out with the substance, only to end their column with a real estate bull saying “but real estate always goes up.” What message does this send to the public? Obviously they get a lot of their money from the real estate syndicate so they are biased even though they would like you to believe they aren’t.

@anon 11:29,

Again, the monthly nut mentality. It all boils down to a zero based budget mentality. Spend until you have zero each month.


Thanks for your comment. No, you are not a chump. In fact, the majority of Americans are not cut out to be real estate investors. That is okay. Not everyone wants to get their hands dirty with property management. You did the right thing with your husband; you live within your means and spend less than you earn. Unfortunately you are a minority.


Rates don’t matter in my view. It’ll break those with adjustable rates but the bubble will collapse even if the Fed becomes totally irresponsible and drops rates again. This bubble will pop.

@anon 8:18,

I appreciate your comments and you’ll see others echo your sentiments exactly. Here is the silver lining; tighter credit will make it harder for people to spend. This will cut back in this frivolous spending which we’ve been living in for nearly a decade.


No shame in selling cars. I sold real estate. Sold real estate in SoCal. How’s that for perspective? But you can do these things ethically and within standards. However the last few years fraud and financial imprudence ran the market.
You are right about the monthly payment. Again, how many people have taken a basic finance course? Only 25% of our population has a bachelors degree. They don’t teach it in high school. So their source for knowledge? Television and the spending happy media.

@mr Vincent,

Good advice.

@anon 1:36,

You are right. If you were to put that extra $140 toward knocking down the loan, you’ll also save long term interest charges and make your loan go away in 23 years as opposed to 30. Not bad.


Everyone needs an emergency savings account of 6 months (3 months at a minimum). This means 3 months of your salary to cover basic necessities. Yet very few American’s have an emergency savings account. Could this be that we spend more than we earn?


Again I think people are slowing down because the mainstream media is printing more anti-housing articles. But the change is only occurring now. And the mainstream media isn’t completely unbiased. Guess who pays for their ads? Many real estate companies do. Have you seen the LA Times real estate section? You might as well let David Lereah be a guest writer each week.


You’re more than welcome to link to the article. Teaser rates are the hook for getting people into over leveraging themselves.


The bubble is bursting. Is there any doubt? We just saw the new DQ numbers and they point to a very bad summer season. If summer is bad, we can easily predict a bottom falling out in Q4 or Q12008. Why? REOs, rate resets, and no more buyers. Recipe for a crash. A crash being a 15 to 20 percent drop. Might as well be technical about it right. But don’t look at the median for the crash.

Anonymous said...

Great blog. Especially appreciate the time you take to respond to individual comments.

Do you think it's possible for prices to fall 30-40% over the next few years in nicer, newer neighborhoods in the Inland Empire, such as Rancho Cucamonga and Corona? I look at the public records for many of the homes on the market and most of the owners are already under water.

My simple calculation is based on halving peak values to get 2000 pricing and then factoring 7 years of annual appreciation at 5%, which is more in line with the long term historical rate.

BTW, waiting for prices to fall also results in a lower property tax bill.

Anonymous said...

Perhaps the reason people are fixated on monthly payments is because thinking long term is too depressing for them. If your income and earning potential don't look great, why even try to save or worry about retirement? Just enjoy life and make ends meet paycheck to paycheck. People are fixated on getting rich quick and that's part of the reason housing became such a mania.

I'm not advocating this approach to life by any means, but just trying to get behind the thinking of those who live this way.


Anonymous said...

One additional comment: as rates rise and property values decline, the power and value of your downpayment will rise too. So, in the 2nd example, you could have achieved an even lower monthly payment if you had applied the $100K as the full downpayment (25% down) and taken out a smaller mortgage.