Home Prices and Interest Rates: The Missing Perspective

In order to understand where the U.S. economy stands from a long term perspective and inform a prudent investment strategy, it is useful to examine the inter-relationship between interest rates and housing prices. That inter-relationship provides an easily understandable case study of interest rate impact on investment assets including homes, stocks and bonds during the past 30 years.

The current interest rate on 30-year fixed rate conforming loans is averaging 4.51% according to the most recent report from the Federal Home Loan Bank Board (Loan Board). On an annualized basis, 30 year fixed loan rates are running at their lowest level since Loan Board starting collecting data in 1971.

Prior to the Depression, home loans typically ran for periods of ten years or less, with balloon payments at the end of the loan term. During the Depression, home loan rates ranged from 6% to 8%. The federal government established a mortgage rescue program in 1933. The Home Owners’ Loan Corporation refinanced and extended loans for15 year terms at 5%.

Following World War II, 20 then 25 year home loans became common. In the five years following the war, rates on such conventional mortgages ranged from 4.6% to 5.3%. In the 1960s, 30 year loans became the norm. From 1946 to 1981, a 35-year period, long term fixed mortgage rates intermittently increased until they peaked in 1981 at 16.83% for a 30-year loan. Thereafter, for the next 30 years, 1981 to the present, long term fixed rates have decreased until they reached their current low levels.

It is especially useful to review the history of mortgage rates since 1980, a period in which the Federal Reserve vastly increased the money supply which brought about asset inflation for homes, stocks and bonds.

1. In 1981, the average rate for a 30-year fixed rate loan reported by Federal Home Loan Bank Board was 16.83%.
2. In 1990, the average 30-year rate was 10.19%
3. In 2000, the average 30-year rate was 8.05%
4. In 2005, the average 30-year rate was 5.87%
5. In 2010, the average 30-year rate was 4.69%

Applying these rates to a 30-year fixed rate $300,000 loan, and assuming a 20% down payment, demonstrates the dramatic impact of this trend on monthly payments:

1. 16.83% (1981 rate) required monthly payment $4236
2. 10.19% (1990 rate) required monthly payment $2674
3. 8.05 % (2000 rate) required monthly payment $2212
4. 5.87% (2005 rate) required monthly payment $1773
5. 4.69% (2010 rate) required monthly payment $1554

In other words, the same monthly mortgage payment on a 30-year fixed rate loan that would have purchased a $360,000 (20% down) home in 1990 will now purchase a $625,000 home. The monthly mortgage payment that would have purchased a $360,000 home in 1981 will now purchase a $975,000 home.

The picture gets even starker when you consider the impact of adjustable rate mortgages. In 2003 through 2006, the majority of mortgages issued were adjustable. In 2003, mortgage lending companies were offering adjustable rate interest only loans (not amortized) with an initial 5 year fixed rate. The monthly mortgage payment on those loans was equivalent to what a 30-year fixed rate amortized borrower would have paid on a mortgage with an interest rate of 0.75%. The monthly mortgage payment that would have supported a $210,000 purchase in 1981 or a $360,000 purchase in 1990, using a standard 30-year fixed rate, supported a $1,015,000 purchase using the five year/interest only option.

Yale Professor Robert Shiller of the widely reported Shiller-Case home price index has indicated that home prices increased at a rate four to five times their long term historical norm during the housing bubble. The homeowner-investor should consider how much home values would have increased between 1990 and the bubble peak in 2006, if the Federal Funds rate had held steady. In fact, the Federal Funds rate was 8% at the start of 1990, then fell to 1% in 2003 setting off a speculative mania.

Lessons To Be Learned

A major driver of home price increases over the past 30 years has been the steady and steep decline in interest rates. Stocks and bonds have also experienced significant asset inflation as interest rates have fallen steeply. The repeated increase in the money supply and drop in interest rates has gone on so long that most homeowners and investors take it for granted. The tailwind of ever lower interest rates is built in to a plethora of economic models and homeowner assumptions. Given that the Fed Funds rate has been effectively zero for over two years, those assumptions should now be questioned.

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