Will Mortgage Rates Really Drop to 0%?
| October 1, 2010 | Posted by Roshawn Watson under Uncategorized |
By: Roshawn Watson
Purchasing a home is one of the biggest financial decisions most people make. The amount you spend on your home often will impact your retirement, ability to pay for the education of your children, your ability to build wealth, and your overall financial solvency.With historically low mortgage interest rates and several depressed markets, this is prime opportunity to buy (or refinance) if you have an adequate financial foundation. In an effort to get more buyers off the fence, mortgage lenders have pondered the implications of aggressively cutting rates even further. What impact would no-interest mortgages have on buying decisions?
Could You Use an Extra Quarter Million?
The prospect of zero percent mortgage rates really got me thinking: just how much does one spend on a 30-year mortgage (assuming no prepayment)? After all, mortgage rates are so freakishly low; surely it’s not that big of a deal. Let’s say that you purchased your home about 5 years ago at 6.5% APR. By the time the mortgage is paid off in 30 years, you would have paid for the mortgage nearly 2.25 times. Simply multiple your monthly payment times 360 to test out the theory. More importantly, this means that 56% of the total amount you pay is interest. Of course, this interest goes to the mortgage lender as profit. Over the lifetime of the loan, that means you are being charged 125% interest.
This point is easier to appreciate using real numbers, the 2005 median home price in the United States was $240,900. If the mortgages were $193,000 (assuming a 20% downpayment) at 6.5% APR, then Americans would end up paying $438,840 (not including downpayment) over 30 years. This also means that we would pay nearly a quarter million dollars interest alone! Since most people could you use an extra quarter million, the interest issue is very relevant to most homeowners (as most have mortgages). Note, if the rate decreased from 6.5% to 4.5%, one would save a noteworthy $85,000 over 30 years (in this example)!
If mortgage rates plunged to zero
Perhaps you may be wondering, why a lender would consider giving up so much profit by cutting rates? As long as deflation is a prominent concern, mortgage rates will continue to decline.
At least, that was the opinion of loan officer Dan Green according to Market Watch. What I found most interesting was the article’s discussion of the feasibility of mortgage rates plunging to zero. Of course, using 0% interest or near zero rates to spur buying behavior is not a new practice. For example, new car buyers expect to pay little to no interest (if they have great credit) as an incentive for financing the vehicles. Likewise for homes, zero percent financing could spur demand to barely containable levels, prompting hiring in the mortgage industry to meet capacity and increased consumer spending due to substantial reduction in monthly payments. However, mortgage industry experts are dubious as to how this economic model could work, since “to fund a 0% mortgage, an investor would get a negative return.” One pragmatic solution would be to implement tremendous fees to borrowers, which would compensate for costs to originate, deliver, and the cost of default, etc.
Unfortunately, the general consensus is that 0% interest is very unlikely, but that doesn’t preclude rates going even lower than the present levels despite record-breaking low rates for 30-year loans. This is primarily because this recession has been very atypical (huge understatement I know). Thus, the predictive value of historical precedent regarding interest rates is not as strong. We experienced a 0.7 point decline in fixed mortgage rates between June 2009-2010, which was the largest over the last six recessions. This means that although declines in rates are common during the 12 months following a recession, the recent decreases in mortgage rates have been distinctively more steep.
Regardless of the Rate, You Must Watch Your Ratios
Often missing in the discussion of mortgage debt is the ratio of your mortgage to your annual income. Thomas Stanley and Chris Farrell both advocate not going over two times your annual income for a 30-year fixed mortgage, and I am inclined to agree. In his book Your Money Ratios: 8 Simple Tools for Financial Security, Chris argues using the following chart as a guideline for your mortgage to income ratio (MIR).
- 25 years old — MIR: 2.0
- 30 years old — MIR: 2.0
- 35 years old — MIR: 1.9
- 40 years old — MIR: 1.8
- 45 years old — MIR: 1.7
- 50 years old — MIR: 1.5
- 55 years old — MIR: 1.2
- 60 years old — MIR: 0.7
- 65 years old — MIR: 0.0
Another conservative strategy is to make sure that your mortgage payment is no more than 25% of your net (take home) salary. In either case, the goal is to make certain that your mortgage is in line with your wages and to enhance the probability of you paying it off. In some more expensive areas, this may mean delaying the purchase of a home until a large enough downpayment can be saved to reduce the total mortgage to a more reasonable size.
As stated earlier, the mortgage has a significant impact on one’s finances. Consider research by Thomas Stanley that showed that those with investible assets of at least $1 million or more were over 2 times more likely to live in a home valued at $300,000 or less compared to those who earned $200,000 or more (but assets less than $1 million). In contrast, people with investments of $1 million or more were only 0.65 times as likely to live in a home valued at $1,000,000 or more (compared to those with annual income of $200,000 or more). The implications are clear. This data suggests it is easier to become (and stay) a millionaire if you live and consume like those who live in modest homes than in expensive homes.
Additionally, the size of a home is a better predictor of one’s mortgage than one’s wealth.
It is particularly grieving to watch my well-educated, high income friends move into upper-middle class neighborhoods even if some of them can barely afford it. Stanley’s data indicates: conspicuous consumption (including status homes) is a better predictor of credit rather than wealth. Please forget looking rich…be rich! I know school districts are a frequent concern for parents. School districts are important but so is not eating Alpo in retirement. Just be pragmatic and show restraint.
Build Your Wealth Not Their Wealth
There’s been much discussion about how we are more frugal now. However, there is rather interesting data suggesting otherwise.Although the lending standards are more stringent today than a few years ago, the lender’s assessment of your financials is only a beginning consideration. Remember, if your end goal is to become financially independent, not having a mortgage would be tremendously advantageous. It is so much easier to save and invest without consumer debt, so imagine what you could do without a mortgage.Being mindful of your money ratios is very prudent. Low interest rates don’t mean much if your home is 55% of your income.
In summary, there is little doubt that 0% mortgage rates would be sweet even if some reasonable fees were levied up front. Although such rates seem unlikely, this is still a great buying (refi) opportunity for those on solid financial footing because the rates are so low. Just remember:
“Every penny of interest you pay is money you have to earn…money that should be contributing to your wealth…but instead you are donating it to the wealth-building of your creditors” (John M. Cummuta).
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Copyright 2012, Roshawn Watson, Pharm.D., Ph.D. All Rights Reserved.
There are some posts that just don't lend themselves to a quick glance. This is one of them, you really cover a lot of ground.
I'd offer a couple comment on what caught my eye. The ratio of mortgage to income. (Disclosure – I read and reviewed Money Ratios and liked it) For simplicity, it ignores the most important variable, the interest rate. The 25% of income is a decent number to use. So, on a $48K income, $1K/mo to the mortgage. Now, at 8%, you can borrow $136K, at 6%, $167K, and at 4% $209K. Ratios of 2.8 to 4.3 depending on the current rate. I'd favor sticking first with the 25% of income number and then if you can find what suits you for less money, just downsize the purchase from there. I do like Charlie's concept of scaling down with age, i.e. no mortgage at retirement.
I was 34 when we bought the house we are in. The rate then ('96) was 7-5/8%, and the ratio was 2.0, actually in line with the advice. At 48, we are at about .8 as I've refinanced many times (no cost each time) and paid extra principal along the way. I am still in line with the ratios as I intend to be able to retire in 7 years, if you look at your table, that fits perfectly.
Note, when we first got the mortgage we were preapproved for more than we wanted. Appears I'm as conservative as Charlie.
The 125% is an eye opener, but not as scary to me as it might be. It's over such a long period that one really needs to understand the time value of money to see why I feel this way. If I offer you $1500 for a $1000 loan (assume I am good for it) it would be one thing to pay it quickly (wow 50% in one year) but if it's 10 years, well, 4.14% is good, but not amazing. Yet "it's 50%."
Excellent writing Shawn, keep it up.
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0% mortgage rate interest is only good if you already own a home. If you don't… get ready for one hell of a price inflation, and then get ready to get shafted if those rates ever rise up a few points. It's a recipe for disaster if not reflected by fundamentals but rather by quantitative easing
I always hit the submit button too fast. 😉
I enjoyed the commentary about how conspicuous consumption = lots of credit, not savings and assets. This is so true… and one very important thing to keep in mind if you ever do want to have the wealth to conspicuously consume a little some day.
Sigh, still submitting too fast.
My personal view is that total carrying costs for the home should be <33% of net take home pay. Looking at mortgage alone does not look at the whole picture.
At current prices in Canada, my rule makes housing on the unaffordable though not the extreme side. Although our income is above the Canadian median (or average, I don't remember), we could not afford a detached house in an area we'd want to live in. We could, however, afford a condo near downtown and next to a subway, so that's what we went for.
I don't think it will ever get to 0%, but it's so low now, and as you state above, the prices of homes are so low too, that I think it would be prudent to take advantage of this one in a life time opportunity now instead of waiting.
I know the guy in the cube beside me purchased a new home just this month! People like my cube mate are going to jump on the opportunities while they exist.
Heck, I'm even thinking of buying a bigger house… (now if I could just convince my family to move) 🙂
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If I had plenty of cash, I'd be shopping around down south right now!
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Kevin,
Really interesting point. I certainly doubt 0% could as our economies improve. However, do you feel that with heavy upfront fees that 0% APR could avoid disaster and work as a business model for the short-term?
My recent post Will Mortgage Rates Really Drop to 0
No problem with consumption…just as long as it reasonable given your reasonable budget! The biggest problem here are those who go broke trying to look rich…it's like sooooo high school 🙂
My recent post Will Mortgage Rates Really Drop to 0
Kevin, I really feel like people are just too anxious on this one, and I was right there too, so I definitely get it. I thought that I was missing out by not owning a home. I didn't do what you did which was going for the condo. I did drive my Realtor insane with my requirements and budget restrictions. I knew enough not to opt for to stretch the budget but I was impatient and wanted my home my way right then. We are seriously thinking about moving, so this whole affordability issue is on my mind a lot lately. I would hate to make a mistake after being so blessed the first time go round.
I'm glad things worked out for you and your GF.
My recent post Will Mortgage Rates Really Drop to 0
Absolutely. I am in love with real estate right now, so the prospect of moving is both exciting and terrifying. Fortunately @moneyreasons and @kevin, it appears that the deals to be had will be around for a while! Who knows what's in store for us!
My recent post Will Mortgage Rates Really Drop to 0
It would basically be an interest pre-paid mortgage? I suppose there's room for such a type of mortgage for those who want to sell it and buy it. Why not?
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We almost went for a condo that would have destroyed us in monthly payments… twice, so we did show some impatience. In the end we wisened up somewhat and decided to go for something that would have far less carrying costs, though absolute prices aren't so much lower. So, we don't have a sauna and a pool… but so what. I predict that had we gone for the expensive units that we both would have been pretty unhappy, and under a lot of money-related stress… especially if rates had risen.
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I don't see deflation in the cards. Certainly prices of precious metals and commodities in general are rising. It's only a matter of time before interest rates rise. The quantitative easing of the Fed may mean artificially low interest rates now, but it won't be that way sometime in the future. This is the best time in the past 50 years to buy a house, assuming you have a safe and steady source of income. Interest rates will probably never be low, and neither will housing prices. Lock in now and make the leap. Buying what the crowd hates has more times than not been a successful investing strategy.
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I wish I could convince my family! I just want bigger house, but not by much… Perhaps another 300 to 400 square feet above the square footage of my existing house would be perfect!
Oh well, as long as the family is happy, I'm happy (sort of) 🙁
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I definitely with you regarding buy now. I would definitely not be holding out for cheaper,as I believe rates and prices are generally going to go up too. That said, I also felt the same way about the rates when we were at 6%, then 5%, and 4%. It's hard to have a good track record under these unpredictable conditions. One thing that I have been wondering about is deflation and inflation occurring simultaneously. Anyway, thanks for the comment! …very insightful!
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Thanks!!! I always enjoy reading and responding to comments. I thought the ones on this post were fantastic!
My recent post Will Mortgage Rates Really Drop to 0
Hey Kris,
That timing would kind of suck, but you would still have the better end of the deal with a paid off home!
My recent post Will Mortgage Rates Really Drop to 0
The rates aren't so much the issue as being able to get a loan! Banks have become quite stringent to the point of being at the far end of the scale they were a few years ago when they gave away loans. Every little things must be in place in order for a loan to go through and buyers need absolute proof of income.
Rates today are amazing! It's getting the loan.
The other problem is that so many people are underwater in their loans and they can't sell if they wanted to. That keeps many homes off the market that some would buy.
The recession seemed to have come quickly but we built up over some time to get where we did. It's going to take some time to build the economy back up. But building back up doesn't mean to where it was before the recession. We were consuming way too much and it couldn't last. We're not going to go back that that level of consumption and home sales for some time and we need to understand that. I think when people look at the current economy they compare it to what it was a few years ago but that's a mistake. We shouldn't have had the economy we had. It was a house of cards that fell at the first big breeze. That can not be the goal.
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Hey Craig,
I agree with you that the lending criteria have definitely become more stringent. This is a correction for misbehavior rather than a punishment in my mind. After all, it was the lack of pragmatic lending that precipitated the global financial problems. I also agree that comparing our current economy to that of a few years ago has it flaws because of the reasons you stated.
Still the rates are great, if you well qualify. As you are pointing out, that's a big "if"
Thanks for sharing your thoughts!
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