Mortgage Interest Rates & Cost/Value of Homes

There has been a lot of discussion recently as to when will we see home mortgage interest rates go down. These rates are largely determined by the Federal Reserve’s position on the economy and their “benchmark interest rate” or Federal Funds Rate. The current Federal Funds Rate is 4.5% with a target of 4.25 to 4.5%.

The Federal Funds Rate is the interest rate that banks and other financial institutions charge each other for borrowing funds overnight on fund amounts, in their accounts, at the Federal Reserve. This rate is generally determined by the banks involved but highly influenced by the Federal Reserve’s policy with regard to their “target” Federal Funds Rate. This obviously affects the rate that these financial institutions charge their customers.

Currently the 30 year home mortgage rate is fluctuating between 6.9 to 6.99%.

However, there has been very little discussion of the 47% increase in the average median home price over the past four years.

In order to understand the effects of interest rates, and home prices, we need to understand a little about history. My wife and I bought our first home in 1962 and our 30 year mortgage rate was 6%. Obviously, home prices were significantly lower then, as were wages. We upgraded in 1963/64 and we paid approximately $22,000. for a new home., With a mortgage interest rate of 6%, 20% down, our mortgage payment for principal and interest (P&I), on a 30 year mortgage, was approximately $105.00 per month. On an inflation adjusted basis, that home would be worth $203,239. and the monthly payment of P&I, on the same terms, would amount to $975.25 per month.

Mortgage interest rates have fluctuated wildly over the past 5 decades. In 1981, the 30 year mortgage interest rate hit an all- time high of 18.63%. However, the average median home price was just a little over $200,000. In 1982, the 30 year mortgage interest rate amounted to 13.24%. It remained double digit until 1990 when it dropped to 9.97%. It continued to drop through the 1990’s, reaching 7.46% in 1999.

In 1999, the average median home price, adjusted for inflation, amounted to $244,151. Between 2000 and 2010, the interest rate fluctuated from a high in 2000 of 8.08% to a low in 2010 of 4.86%.

In 2008, the United States, as well as a number of other countries, experienced a significant economic disaster due to a sharp decline in the economy. The decline was fueled by a word wide collapse of a “housing bubble.” Housing prices dropped and the construction industry was seriously affected.

The crash was due to a number of factors. One of the largest contributors to the crash was the “sub-prime mortgage crisis.” Loans were given to individuals that really did not have the financial means to repay them. They generally had bad credit scores, and a history of late payment. These loans carried higher interest rates to compensate the lender for the higher risk. Many loans were adjustable rate mortgages (ARM). These loans carry an initial low interest rate, and then over time adjust to a higher interest rate. All of these loans have low down-payments and one must pay a premium called Private Mortgage Insurance (PMI) until their loan balance was less than 80% of the value of the home.

When the ARM mortgages started to adjust, people were unable to continue making the higher payments and defaulted on their mortgages. As a result, there was a ripple effect in the market. Banks and financial institutions incurred significant losses and were left holding mortgages worth a fraction of their face value.

Millions of homeowners lost their homes, and jobs, and housing prices fell over 27% from their peak in 2006.

Prior to the collapse, it was reported that millions of mortgages were bundled into securities and sold world-wide. Banks and hedge funds had borrowed heavily against these securities, and as their value dropped, banks collapsed, and mortgage companies had to be bailed out by the Federal Government. The U.S. Stock Market dropped over 40%. Bankruptcies were rampant.

As a result, the Federal Funds Rate dropped to between 0% and .25%, and mortgage interest rates plunged. In 2009, the 30 year interest rate was 5.38% and in 2021 it reached a low of 3.15%. Between 2010 and 2021, the rate fluctuated between 3.15% and 4.86%.

However, home prices began rebounding, due to a number of factors. Soon after the collapse, private equity firms began buying single family homes for rent. It has been reported that they now own over 239,000 homes for rent. In addition, low interest rates fueled an increase in home prices. Covid had an impact. Firms went to remote work, and employees moved to lower cost areas, which in turn tended to increase home prices in those regions. New home construction decreased.

There are three methods for determining the value of a property; the cost, the market, and the income approach. The cost method is fairly simple. What would it cost today to rebuild my home? The market approach involves comparing your home to those that are similar and have sold recently. The income approach assumes that the owner is receiving income from the property (rent) and wants a reasonable rate of return. Generally the fair market value of a property is the lowest of the cost or market unless it is income producing.

Private equity firms, as well as hedge funds, became interested in homes as an investment when the housing bubble burst and home prices dropped. They found that investing in homes, and renting them, resulted in higher returns than what they were receiving on other investments in their portfolio. As an example, assuming they wanted a 10% return on their investment, and they could get $2,000. a month rent from a home, that would result in a value of $240,000. If their target return was 5%, then the value would escalate to $480,000. These organizations found that they could purchase homes for significantly less than their true value, rent them, and obtain higher rates of return.

Since then, these same firms expanded into the apartment market, and today own over 1 million apartments. Apartment rents have increased significantly, because of the shortage of single family homes, and increased cost to rent them. The size of apartments have decreased, to where 850 sq. feet is a “large apartment” today.

More apartments have been, and are being built today, because of this phenomena.

All of this has resulted in less inventory on the market, and the old economic principle of “supply and demand” took over. Higher demand, and lower supply, equals increases in prices. From 2020 through 2024, it has been reported that the average median home price has increased 47%. As of October 2024, it is reported that the average median home price is $417,461. The 30 year mortgage P&I on that, with 20% down ($83,488.), results in a monthly payment of $2,194.41. If insurance and property taxes are included, the total monthly payment is over $2,700.

It has been reported that higher interest rates are the contributing factor in why there are not more home sales. It is one factor, but there are others. Lower inventory because of private equity purchases, less building of new homes, low interest rates during the 2008-2020 recession, have all had an impact on higher housing prices.

Will housing prices continue to increase? I looked at the financials of D.R. Horton, NVR, Inc. and Toll Brothers. Horton is the largest home builder in the United States. NVR, Inc. is considered number 4 and Toll Bothers is considered number 11.

Horton had revenue for the year ended September 30, 2024 of $36.8 billion and net income of $4.756 billion. This is a 12.9% return on revenue. Their free cash after repurchasing $1.871 billion in stock, from stockholders, amounted to $2 billion.

NVR, Inc. consists of Ryan Homes, NV Homes and Heartland Homes. Their revenue for the year ending December 31, 2023 amounted to $9.5 billion and their net income was $1.591 billion or 16.8% of revenue. Free cash flow amounted to $1.473 billion after the repurchase of $1.082 billion in stock.

Toll Brothers revenue for the year ending October 31, 2024 amounted to $10.846 billion. Their net income amounted to $1.571 billion, or a return on revenue of 14.48%. Free cash flow amounted to $936.5 million after the repurchase of $627 million in stock.

All have seen favorable financial results, and have taken advantage of a decrease in their stock price, by repurchasing significant shares of stock from their shareholders. This approach tends to increase the value of the remaining shares, as there are fewer shares outstanding. If an organization has adequate cash flow, and no alternative investment opportunity, repurchase of stock may make sense.

It is my opinion, without any evidence, the financial results of these organizations are the direct result of increasing home prices without corresponding increases in costs.

The high prices of homes, even with current or reduced interest rates, still price the majority of people out of the market. At a median average cost of a home over $400,000., the purchaser must have at least $80,000. to put down. The monthly payment for P&I, on a 30 year mortgage of $320,000., amounts to $2,126.82. If one assumes that taxes and insurance amount to another $400.00 per month, the total monthly payment would amount to $2,526.82 per month.

In 2023, Forbes Magazine published an article entitled “ What Percentage Of My Income Should Go To Mortgage.” In that article, they state that one method of determining how much home one can afford is to use the 28% rule.

This means that one should not carry a mortgage where the monthly payment of P&I, as well as insurance and other costs, exceeds 28% of your monthly gross income.

Lenders generally look at all of your debt, and calculate a debt to income ratio (DTI). In this case, they prefer that one’s DTI payments be between 36% and 43% of gross monthly income.

As an example, assuming gross income of $5,000. per month, and 40% as a DTI ratio, total monthly debt payments should be no more than $2,000. per month. Assuming the purchase of a $400,000. home, a person making $5,000. per month would not qualify.

Monthly payments for P&I on a 30 year mortgage of $320,000, assuming a down payment of $80,000, would amount to $2,126.82. If you added, $400. per month for taxes and insurance, the total monthly payment equals $2,526.82. On that amount, one would need a monthly gross income of $6,317.or annual income of $75,804.

That also assumes that one would not have any other debt payments ( credit cards, school loans, etc.). If a person had nominal monthly debt payments of $500.00 per month, and a mortgage payment of $2,526.82 ( including P&I and taxes and insurance), then they would need a gross monthly income of $7,567. or annual gross income of $90,804.

Is it no wonder there is a housing issue today? What does the future hold? That is the $64 question! Will we see a repeat of the 2008-2010 financial crisis, because of the rising home prices, and existing homeowners using that increase in value to increase borrowing, using Home Owner Equity Lines of Credit (HELOC) or fixed rate home equity loans?

Will there be another housing bubble collapse? I hope not. I believe, however, that there will continue to be a shortage of inventory because of the continuing private equity purchases, and those homeowners with low interest rates, not wanting to sell. Until homebuilders see fit to increase their production at reasonable prices, this will continue to be a never ending crisis. That is something that will not, and cannot, change overnight. Lower interest rates alone, are not the answer.

Jess Sweely

Madison, Va.