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.