Is The Value Of Your Home Going To Fall As Rates Rise? 3
In order to see why this is the case, let’s go back to our example of her selling her home into a bullish market.
In all likelihood, she will also be selling during a period where mortgage rates are high.
Because demand for homes, and thus mortgages are high during a housing bubble.
Think about this from a bank’s perspective. If more and more people come in looking to take out loans to buy homes, i.e. demand is high, what is the rational business decision to take?
Charge them more, of course!
Which, in terms of a mortgage, simply means a higher mortgage rate.
Consequently, higher mortgage rates don’t necessarily lead to lower home prices. As a matter of fact, higher rates strongly indicate growing bullishness, if not exuberance in the housing market.
If you remain unconvinced, or skeptical by this simple explanation, it’s probably because you are caught up in the interest rate fallacy. This fallacy mistakenly associates higher interest rates with a shortage of money, and lower rates with an excess of money.
In reality, the opposite is true for two reasons.
The first has already been explained above, where banks loan more money (increase the money supply) when demand for loans is strong, and charge more for it (interest rates rise).
Therefore, an increase in money supply comes with an increase in interest rates.
Secondly, interest rates are also subject to the effects of hoarding. But the hoarding of what, and by whom?
It’s the hoarding of loans by banks.
Without getting into too much detail, banks have to hold a certain amount of capital against their assets. The riskier the asset, the more capital it requires. Since mortgages are assets to a bank (because they earn money from the interest), bank managers need to hold capital against the mortgages they make.
More importantly, they also need to ensure that the return on the mortgages they originate is enough to justify the amount of capital held against it, on a risk adjusted basis. If it doesn’t, the bank is better off using that capital to back some other asset with a more attractive risk/return profile.
Consequently, in order to make best use of their available capital, banks need to make mortgages to the most creditworthy clients, since they present the lowest risk profiles.
In other words, banks are hoarding their capital; in terms of only originating mortgages to those most likely to pay them back, and not everybody else.
This is best expressed in the chart below, of the Housing Credit Availability Index (HCAI).
As you can clearly see, mortgage availability has shrunk considerably since the bursting of the US housing bubble in 2007-2008, with lenders becoming increasingly intolerant of defaults by borrowers.
The direct consequence of this hoarding is that banks end up competing for the same relatively small pool of very creditworthy clients.
Lower mortgage rates of course!
How else would a bank tempt a very creditworthy client, who is spoiled for choice of banks to choose from, to borrow from them?
To be continued…
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