Topics: Mortgage Rates, Housing Affordability, Personal Finances

I had a few social events this weekend, and many of my conversations hit the three main categories of conversation: Politics, religion, and economics.

I was thriving.

What I heard the most was this…

“When mortgage rates come down, I’m going to *insert one of the below options*.”

• “Buy my first house”

• “Buy an investment property”

• “Sell my house”

• “Refinance my current mortgage”

A couple of unfortunate souls got to hear my raw, numberless thoughts on mortgage rates and why waiting on lower rates is probably a bad idea. To avoid future conversations like that, I wanted to share this :)

Mortgage Rates - What are those?

This chart is impacting numerous people’s financial planning decisions right now: it’s the average 30-year mortgage rate you can expect to pay on a mortgage.

A mortgage = Debt that you take out against the value of the house. Typically you put a down payment on a house and finance the rest of your purchase using a mortgage.

Mortgage rate = The interest rate you pay on the mortgage. It is influenced by a couple of factors:
- Risk-free rates (more on that in a sec)
- Duration (term of the loan)
- Risk (AKA risk premium, credit spread, etc - influenced by your credit score)

Before we dive into when rates will fall, let’s first talk about why it’s a bad idea to make financial planning decisions on the direction of interest rates in the first place.

Financial Planning - Why timing the market isn’t a great financial planning strategy…

The rule of thumb is that no more than ~30% of your gross income should go to your mortgage payment. If you run the numbers and you’re over that amount, you have a couple of options:
- Make mo’ money
- Increase yo’ down payment (thereby reducing your total debt amount)
- Pay a lower interest rate

Instead of pursuing the first two options, many people are focused on getting a lower interest rate. However, the only things people can do to impact their mortgage rate (without accounting for differences between fixed and variable mortgages) are increasing their credit score, shortening the mortgage duration, putting more money down upfront, or timing the market correctly (technically you can buy the mortgage rate down, but I’m going to leave that out for now). Of these four, many people focus on the last option: timing the market.

It’s easy to shorten the duration of a loan and/or increase your down payment (as long as you have the flexibility to do so). Increasing your credit score can also have a material impact on your mortgage rates (can reduce your mortgage rate by as much as ~2%). More on all these in a sec.

But still… Bruh. We’re relying on the only thing we cannot control.

Let’s do a simple example:

Bob has $50K in gross income and is looking at buying a $250K house with $50K as a down payment. Let’s also assume he wants to do a 30-year mortgage, which would mean an interest rate close to 7.5% if he has a reasonable credit score.

If Bob moves forward, he’d have a $1,405 monthly mortgage payment ($16,860 annually) - this equates to 33.72% of his gross income. Red flag.

He talks to his buddy Jake, who tells him that his decision is “mid”. But he says that he’s just going to refinance once rates go lower.

What our buddy Bob hasn’t mathed out yet is that it’ll require interest rates to decrease to 6.39% for him to get to that 30% ratio - over a 1% decrease (not including refinancing fees, which are 2-6% of the loan amount). In the meantime, he’s paying more (albeit not a whole lot more) than he can afford and is sacrificing either his retirement contributions, debt payments (yikers), discretionary spending, or emergency fund (yikers x2) to do so.

For people who have or will buy a house in the near future, this is exactly what’s happening. Here’s the current situation:
- Median housing prices: $420K
- Median family gross income: $92,750
- Average mortgage rate: 7.03%

For people who decide to buy a home now, it puts them close to a 30% mortgage payment relative to gross income for the average American. Yikers x 3.

For the average American with an existing mortgage, that ratio is closer to 10%. Nice.

If your situation (such as starting a family) requires that you buy a house, go ahead and send it; just know that you’ll have to sacrifice something in order to make that happen, at least in the short-term and perhaps in the long-term. Even with all our charts, we’re still guessing what’ll happen to interest rates.

With that being said…

Where are Interest Rates Going?

Let’s deconstruct the drivers of interest rates:

Risk-Free Rate: This is the interest rate the US government pays on its debt, hence why it’s “risk-free” (let’s debate their riskiness later 😉). Risk-free rates are driven by the Federal Reserve via monetary policy, inflation expectations, and currency stability. Over the last 4 years, risk-free rates have increased from higher interest rates by the Fed and higher expectations for inflation.

Before we go on, you’re probably thinking “well, the Fed’s going to cut this year, so mortgage rates will go down.” If you’re saying that, you probably read an article like this. You’re missing a lot of context.

Without going into too much detail, the Federal Funds Rate (which is the rate most people refer to when they talk about “rate cuts”) is the rate at which banks can lend excess deposits to the government overnight. It’s overnight, so the maturity on this facility is technically one day at most. Here’s how this “one-day maturity” looks relative to the rest of the debt the government issues:

The red arrow is the rate that is most influenced by the Federal Funds Rate, while the green circled rates are also influenced pretty heavily by changes to this rate. The rest are based primarily on expectations for what will happen to interest rates in the future. The inverted yield curve tells us that people think that short-term interest rates are going to decrease in the future. To be clear… investors are already accounting for future rate cuts.

If I were a betting man, which I’m not, I’d bet that the next rate cut won’t impact mortgage rates by very much, because we’re already accounting for some degree of rate cuts in the future.

Risk: Risk is driven by your credit score, downpayment amount, and some other intangibles (like your relationship with the bank). It’s measured by the "Mortgage Risk Premium” or credit spread as us finance nerds call it.

For a thirty-year mortgage, you’d take the 30-year risk-free rate and add the Mortgage Risk Premium (in blue below).

The combination of more “risk” and higher risk-free rates has driven mortgage rates higher. The “risk” comes from lower average savings rates, increasing delinquencies on credit cards and auto loans, and some other metrics.

Duration: How long is the loan outstanding? The longer the loan is outstanding, the higher the interest rate will be; this is because it increases risk for the bank in terms of a) interest rates increasing and them not being able to lend at a higher rate in the future and b) the longer a loan is outstanding, the less likely full repayment is. To increase your mortgage from a term of 15 years to 30 years, you can expect your mortgage rate to increase by ~0.7%.

A Summary on Mortgages Rates:

Call me crazy, but I don’t think mortgage rates are that high - I just think they are high relative to our recent experiences. Not to sound like a boomer, but mortgage rates were way higher in the 70’s and 80’s.

I think that risk-free rates on 10-30-year treasuries will continue to be elevated, that risk premiums for mortgages will either remain at current levels or increase more, and that term premiums will continue to vibe in the 0.5%-0.7% range (fairly safe guess).

In aggregate, I think mortgage rates will stay at the current level for a bit longer than everyone else expects.

Something has to give in the housing market, though, as housing affordability is the worst it’s been since the 70’s-80’s. Houses could get more affordable through artificially lowering mortgage rates again, but I have a suspicion that it’ll be through lower housing prices (not a formal prediction or forecast, but just an observation that very few of us are going to be able to buy homes anytime soon with the current conditions in the housing market).

*There’s a lot more that goes behind assumptions and expectations like these, such as consumer sentiment, savings rates, GDP, CPI, etc. How you view the current economic climate will influence how you interpret these numbers.

Let’s Wrap This Up

I’d love to buy a house or investment property, but DANG it’ll be expensive… Way more expensive than I’m good with.

Lots of people are making financial planning decisions on the future of mortgage rates. I’d tell them that their decision is “mid”.

Housing prices are high and mortgage rates have increased a LOT due to higher risk premiums, higher inflation expectations, and a higher Federal Funds rate than previously expected.

Make a decision that works for you in your circumstances - don’t expect interest rates to change based on your financial situation, they often don’t.

There’s more you can do to reduce your mortgage rate other than timing the market, such as increasing your credit score, putting more down on a house upfront, and reducing the duration of your loan.

Thanks for reading. Till next time…

Stay synergized.