Will recent low interest rates stunt future Austin move-up activity?

by Steve Crossland, REALTOR in Austin TX on December 16, 2010 · 18 comments

One of our buyers closed last month with a 3.87% interest rate. We saw many sub-4% loans the past several months, though rates have now climbed back above 4.6%.

Let’s imagine hypothetical first time buyers with a toddler who closed this year with an interest rate below 4%. Fast forward 5 years to 2015 and imagine they now have a 6 year old and a 3 year old. The career is going well, income is up, savings account is healthy, cars and student loans are paid off, the economy is good and the house is starting to feel a bit small.

This is the profile of a typical move-up buyer in Austin. Move-up buyers play an important role in the real estate market by providing resale housing stock for first timers to buy and, simultaneously, providing demand for the mid and upper range homes in Austin. We need this “move-up churn”. It’s good for the real estate market and Austin’s economy.

But now let’s also imagine that in 5 years from now that the best interest rate available on a new mortgage is an unfathomable 6.75%. Don’t think it will go that “high”? That’s not ever a “high” interest rate! And yes, it will get that high again – eventually. How hard will it be for a move-up buyer to let go of that 3.75% loan on the current home? Very hard, I’m going to bet.

I think the psychological urge to hold onto that loan is going to be very strong.  And I think it will factor into the move-up decision more than we may currently realize.

We now have a large percentage of the home buying population who’ve never seen an interest rate above 7%. I’m still paying 8% on two loans I have from 2001. I thought 8% was a good rate at the time, for investment property. Historically, for most baby-boomers, anything below 7% or 8% has been a decent interest rate, because those are the rates we’ve always known – up until the mid-2000′s. Now, the “new normal” for interest rates is below 5%.

Moving up from a home with a 4% interest rate to one with a 6 or 7% interest rate creates a different math equation than making the move with an interest-rate-neutral new loan, or as in recent years, getting more house while also dumping a higher interest loan in exchange for one at an historic low rate.

Let’s see how it looks on a chart and how the math worked out for a recent move-up buyer, going from an interest rate in the high 6′s to an interest rate of 4%.


Recent 2010 Move-up Scenario to Lower Interest Rate

Existing Home Move-up Home % increase
Purchase Price $200,000
2010 Value $225,000 $300,000 33%
Interest Rate 6.75 4.0 -41%
Prop Tax $431 $575 33%
Insurance $94 $125 33%
Princ+Interest (PI) $1,038 $1,146 10%
Total PITI $1,563 $1,846 18%


Under the above scenario, a buyer gets a home that is 33% better (measured by market value) but does so with only an 18% increase in monthly payment because the principle + interest portion of the new payment is only 10% ($108) higher than the old payment. Of course the taxes and insurance are 33% higher because they are a function of value. Still, not a bad deal from a monthly budget standpoint, right? The buyer get’s a way better home with barely a $300/mo. increase in total payment.

But let’s see what the same scanario might look like in 5 years, with interest rate on the new loan increasing instead of decreasing.

Austin Move-up Buyer Scenario for 2015

Existing Home Move-up Home % increase
Purchase Price $200,000

2015 Value $225,000 $300,000 33%
Interest Rate 4.00% 6.75% 69%
Prop Tax $431 $575 33%
Insurance $94 $125 33%
Princ+Interest (PI) $764 $1,557 104%
Total PITI $1,289 $2,257 75%



For our hypothetical 2015 move-up buyer, in order to get a home that is 33% better, the buyer will have to be willing to accept a 75% increase in monthly payment (PITI), and a whopping 104% increase in the principle + interest portion of the payment. That’s almost a $1,000 increase in the monthly payment whereas our 2010 buyer accomplished the same move-up with only a $108 bump in monthly payment. What a contrast.

If I were this future move-up buyer, I’d be comparing a move-up to another option. How about a home remodel with $50K loan at 8% on a 15 year note that will increase the monthly payment by only $478?

Finally, if the belt tightening of Americans continues, and baby boomer go on a housing diet as empty-nesters, more people might be moving down instead of up. Sylvia and I relocated to a smaller, cheaper home in Westlake this year. In doing so, we paid off our $400K loan on the old house which had a 5.95% interest rate and obtained a new $270K loan at 4.75% (we missed that 4% bubble as we locked in last June). Thought we were mostly motivated by getting into the Eanes ISD, the financial effect of the move-down was turbo-charged by the accompanying drop in interest rate. Future move-down people, if leaving behind a 4% interest rate – even on a higher loan amount – will realize less of a budget advantage than we are enjoying.

Of course time will tell, and nothing can be accurately predicted, but I do think those Austin buyers who were fortunate enough to obtain loans at or below 4% are going to covet those loans and find themselves feeling resistance toward doing a trade up such as the one outlined above.

{ 18 comments… read them below or add one }

1 Donna December 16, 2010 at 1:29 pm

4% is a great deal, it’s always better to pay yourself than to pay the bank. However, can’t let it spoil your budgeting discipline, so either
1) hold on to the property for as long as possible since the interest is so low (by expanding or renting out).
2) make mortgage prepayments to get adjusted to what a higher interest rate would be like. Except in this case the extra money goes to pay down your principle, not your interest.

2 Brandon December 16, 2010 at 3:01 pm

My wife and I are in exactly this situation. After failing to sell our house last year, we went ahead and refinanced at an incredible rate. I figure it was a no-brainer since the payback time was under 6 months. The goal is to re-list next spring but if rates continue to rise it’s going to be awfully hard to justify moving. Our existing home is fine (good condition, big, Eanes) but we’ve been hoping to move a bit more central. It was already a stretch to justify moving central into a house twice as old and half the size at the same price, but it will be even more difficult to justify if our interest rate jumps a couple points in the meantime. Even now just a couple weeks after closing our refi, rates have already reached the upper limit of my comfort zone.

3 Pat December 16, 2010 at 4:57 pm

Interest rates should not be the deciding factor for a home purchase. (You’ve said this before yourself.) When the time and place is right for you, it’s the right decision. I think the banking and real estate industries create a lot of unnecessary anxiety over prices and interest rates. It’s only four walls and roof, after all.

4 Steve Crossland, Austin REALTOR December 16, 2010 at 5:08 pm

Hi Pat,

I agree that interest rates should not be the deciding factor for a home purchase, but here I’m specifically talking about the move-up decision. For a freshly married couple, doing well and wanting to settle down and start a family in a neighborhood that like, yes, they should not sit around waiting for the perfect “time”. Same with relo buyers who absolutely know they don’t want to be renters.

But move-up buyers have a different set of factors because, often, it’s not a “must” move and they are already home owners. So it becomes more of a “trade” equation and, as with refinancing, people tend to be much more aware of the math than they are when moving from renter to buyer.

Brandon: Thanks for your comment. You an example of a home owner who may have become more “sticky”, that is, less likely to move, because of a great interest rate that you are reluctant to give up.

Donna: Good suggestion about mentally assuming a higher payment to inoculate against the shock of a future move-up and to more rapidly pay down the loan.

5 TH December 17, 2010 at 8:14 am

Steve,

Interesting post. As Donna mentioned, I think you will see more and more people become ‘accidental’ landlords. That’s been happening a lot now due to failed sales efforts. And if interest rates rise, I think it will be more appealing to that move-up buyer. If in the right neighborhood, that $200k house could rent for $1400-$1450 today. In 5 years, with moderate rental increases (which should occur with escalating interest rates), that house could easily rent for $1600/mo. Your move-up buyer should have enough free cash flow to pay for management, repairs, and turn-overs, while still seeing this low interest mortgage being quickly paid down.

I don’t know of a lot of move-up folks, though, that have gone through the hassles of moving for a $75k increase in value. I think your start home move-up is more likely to make the jump to a ~$400k home in Circle C, Steiner, etc.

I do find it interesting that you bring up the interest rate’s impact on people’s home-ownership decisions, but in your last post you down-played any impact that MID might have on the market.

Tim

6 Steve Crossland, Austin REALTOR December 17, 2010 at 8:36 am

Hi Tim:

> I do find it interesting that you bring up the interest rate’s impact on people’s home-ownership decisions, but in your last post you down-played any impact that MID might have on the market.

I know. It’s weird, but of all the “cost of ownership” variables that buyers have to consider, the interest rate and closing costs are by far first and foremost in their minds. Often to the level of neurotic obsession and frantic loan shopping, over a few hundred dollars in closing costs or 0.125 difference on the loan rate, and extreme anxiety over whether and when to lock.

Meanwhile buyers seem oblivious to the other “total cost of ownership” variables, such as the property tax rate difference between Belterra and SW Travis County for example (almost an entire $1 in difference), total cost/value of commute, HOA Fees/Rules, and, of all the things we never hear them discuss or think about, the income tax implications of owning a home.

In my previous post, I wasn’t saying that the tax deduction is not a valuable benefit, just that it doesn’t seem to be a deciding factor as to whether or not to become a home owner instead of a renter.
Steve

7 Brandon December 17, 2010 at 10:09 am

When interest rates are this low, even a fairly small difference can become a major change in the cost of ownership. I expect I would get a rate around 5% on a 30 fixed if I buy next spring, compared to my current loan in the low 3′s (a 7-ARM which is plenty long enough to outlast my need for this house). The rate difference is less than two points, but the monthly payment would be almost 25% higher for the same mortgage balance (and also include less principal). Furthermore my property tax could nearly double for the same value house, just by the combination of moving to a higher rate and potentially being tax appraised as high as 100% of the purchase price. The cost of staying put is remarkably low for anyone who refinanced or purchased lately. I think Steve is right, this will have a huge impact on discretionary moves for the next several years.

For what it’s worth, many discretionary moves (such as my own) are not about moving to a higher priced house. They’re about moving to a different house that suits one’s needs better.

8 Shilli December 17, 2010 at 10:16 am

Another way to think about it is if you have a $200k mortgage at 4%, and prevailing interest rates have risen to 6%, you are effectively saving $4k per year by keeping your mortgage in place (= $200k * (6% – 4%)). Any decision whether to pay of the mortgage should take into account the fact that you will lose that $4k per year. That won’t be enough to keep everyone from paying off their mortgages, but probably some people.

9 Brett December 17, 2010 at 3:27 pm

You people got it all wrong… you buy when interests are high because prices will come down!
Haven’t you learned anything from the housing bubble?
House prices/monthly payments cannot go up forever if salaries do not adjust… people will simply be underwater and will default!
Most people don’t look at the price of the house; they look at whether they can afford the monthly payment.
If the monthly payment goes up because interest go up, people will buy cheaper homes that fit their budget… something has to give!

10 Doreen Zelma December 21, 2010 at 9:44 pm

The trend is also leaning to start living with less. It will be interesting so see what truly defined as a move-up in the future as it is ‘green’ to live in smaller spaces.

11 Woody December 22, 2010 at 7:56 am

Another great article. I have to agree with Brett though, higher rates (if they happen) are not going to be good for housing. The people who really made money out of this interest rate cycle bought in the 80′s with rates in the high teens and prices in the toilet. They refi’d all the way down, often taking out large amounts of cash along the way to buy cars, vacations and the like. We are talking about an enormous transfer of wealth as new buyers paid higher and higher prices for the next 25 years or so. This cycle in reverse will mean pain for homeowners. It cannot be any other way. Take more and more buyers out of the running for any particular home, which higher rates will certainly do, and the price will fall.

12 Steve Crossland, Austin REALTOR December 22, 2010 at 8:55 am

Hi Brett,
> You people got it all wrong… you buy when interests are high because prices will come down!

History proves otherwise. Prices rose in Austin from the early 1990s through early 2000s, a period of interest rate that remained above 8%. Then, when interest rates began plunging (following the tech bubble bust in 2000 and then 9/11), prices in Austin remained flat for 4 years straight. It was only when the real estate bubble lost steam in Cal, Nev, AZ, FLA that “investors” flocked to Austin and helped our prices spike in 2007.

Timing a purchase according to interest rate cycles would be folly. But I do think, as this article suggests, that once people have an interest rate at or below 4%, they will be reluctant to let go of that loan.

I agree with the other comments that “moving up” might be redefined to “moving to a better fit” in the future. We did exactly that, trading a nice newer custom home for a location that better suits our lifestyle needs.

Steve

13 Ray December 24, 2010 at 1:35 pm

Will be a tug o war between sitting tight with 4% interest vs chasing the price train leaving the station on the ‘dream’ home. Especially true if dream is downtown where train will accelerate faster due to simple geometry – area (thus number houses available) proportional to square of distance from downtown.

14 Austin Music Diva December 27, 2010 at 3:00 pm

Well, that’s a depressing thought, and probably true. But you can always tell people to buy whatever you can NOW while the moneys cheap, and KEEP it. Yes, they can move up later, but still keep the ‘cheap money’ house.

So. later on if you have a couple singing the blues about the higher interest rate, at least they should try and keep their original purchase as an investment.

15 Susan MacEwen January 4, 2011 at 8:35 pm

Great post Steve! My husband and I are getting ready to move up in a couple of weeks. We were able to take advantage of the low new construction pricing here in Augusta. I was hoping for that sweet spot in the interest rates at 3.75% but by the time we were within 45 days they had risen just slightly to 4.25%. Which is still a good rate.
What I am wondering with all the V.A. loans in our market (which are usually assumable) is how that will play out in a few years when rates are higher. Makes the real estate market interesting to say the least.

16 Mike January 6, 2011 at 10:23 pm

Steve, what would you say to someone who was refinancing with a 3.9% rate on a 10/1 ARM. I honestly couldn’t see saying in our current home more than another 10 years so I’m willing to take the risk. Your thoughts?

17 Steve Crossland, Austin REALTOR January 7, 2011 at 10:46 am

Hi Mike,

I think most people assume interest rates will be rising long term. Personally, I never use anything other than fixed rate loans. I just like predictability and I assume I’ll keep everything long term even if I don’t intend to when I buy it.

Steve

18 Shawn January 11, 2011 at 9:28 am

Great post. I have been running the same #’s and believe that those with ultra-low rates from 2009-2011(beyond?) will be in a unique situation down the road. Although I agree that the numbers shouldn’t be the only factor in moving up, away, down, whatever; they do play an important psychological role. It may prove difficult for your client in the 3%’s to go to 6,7, or 8 just to have a more desirable/bigger house. I agree that remodels and expansions could be a cheaper alternative.

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