Ownership Cost: Interest Rates and Downpayment Requirements

Federal Reserve interest rate support is a major reason not to buy a home. When these supports are removed and interest rates rise to market levels, loans will get smaller and prices will go lower — when the shadow inventory finally arrives.

4 EARLYMORN Irvine, CA 92614 kitchen

Irvine Home Address … 4 EARLYMORN Irvine, CA 92614
Resale Home Price …… $1,150,000

Darkness falls across the land
The midnight hour is close at hand
Creatures crawl in search of blood
To terrorize y’alls neighborhood

I’m gonna thrill ya tonight, ooh baby
I’m gonna thrill ya tonight, oh darlin’
Thriller night, baby, ooh!

The foulest stench is in the air
The funk of forty thousand years
And grizzly ghouls from every tomb
Are closing in to seal your doom

And though you fight to stay alive
Your body starts to shiver
For no mere mortal can resist
The evil of the thriller

Thriller — Michael Jackson

The foul stench in the air is the fetid paper on the books of the Federal Reserve.

Today is part 2 in the ongoing series on Ownership Cost:

Ownership Cost: Income, Payments and House Prices

Ownership Cost: Interest Rates and Downpayment Requirements

Ownership Cost: Property Taxes and Mello Roos

Ownership Cost: Taxes and Opportunity Costs

Ownership Cost: Homeowners Associations

Four Major Variables that Determine Market Price

Yesterday, we discussed the four variables that determine the purchase price of a property:

  1. borrower income,
  2. allowable debt-to-income ratios,
  3. interest rates, and
  4. downpayment requirements.

Today we are looking at interest rates and downpayment requirements.

Interest Rates

Interest rates go up, and interest rates go down. Interest rates are
the yield on debt instruments. If investors lose their appetite for
mortgage debt, prices of mortgage-backed securities goes down, payment
yields go up, and mortgage interest rates go up with them. This concept
is important to understand because right now, the Federal Reserve is the only buyer of agency paper at price levels yielding 5%.

Private investors are demanding higher returns due to the obvious
risk of loss in a declining market. The Federal Reserve feels it needs
to step in to stabilize crashing markets by preventing an
over-correction in risk premiums to make the free-fall worse. In
crashing markets, 8% mortgage interest rates probably do not warrant
the risk of default loss.

The FED will retain this defensive market safety net until risk
premiums and market mortgage interest rates get close enough to their
support price that they can begin to unwind the program. It isn’t
likely that private investors will return to buy mortgage debt at 5%
yields any time soon, so the FED will have to be cautious in how it
unwinds its supports.

This government intervention underscores the difficulty of
forecasting interest rates and how fluctuations will impact the housing
market. Think back to early 2008 when there when people still denied
the housing bubble. Nobody imagined the Federal Government would assume
ownership of the GSEs (at the time they were private companies), and
that the Federal Reserve would be buying GSE paper at over-market
prices. These unprecedented events would suggest a market cataclysm —
the fodder of conspiracy theory nutters. Yet, here we are.

Interest Rates have a major impact on how much someone can borrow.

The big fear rational people have is that mortgage interest
rates will rise back to historic norms of 8% or go even higher. If this happens, the
housing market can easily drop another 30%. This may be the fate of
Irvine. As I look around at other nearby markets, they have already
fallen to the point where nice properties that would be above rental
parity here are trading for cashflow investor levels. A 30% drop in
affordability in beaten down markets will not necessarily push prices
lower because they have already overshot fundamentals. Irvine is not
trading below rental parity or below historic norms; it has a long way
to fall.

The chart above illustrates an important financing point and a legitimate reason not to buy a house.

it will be interesting to track the future and see where mortgage interest rates peak during the next cycle. If we really do get a 2011 Inflation Spike, it will be much higher than 8%. It is realistic to believe mortgage interest rates will hit 7.5% at the peak of the next cycle in 2013. Are they staying at 5% forever?

The table shows how rising interest rates will effect median price in Irvine at rental parity. What happens if mortgage interest rates are allowed to find a natural market? How do we know where the natural market is?

Currently, prices yielding 5% do not catch the long tail of market demand. The Federal Reserve is buying 100% of the agency paper. If prices were at market clearing prices, the Federal Reserve would be buying 0% of the agency paper market. The long tail of demand may be very near the natural market clearing price, or it may be very far away.

I am inclined to believe it at least as far away as the 6.76% peak of the last cycle in July of 2006. At the peak of that cycle, financial markets were delusional about mortgage risk at the peak of the housing bubble. Risk premiums are certain to be higher now.

If interest rates merely reach the previous peak, it removes 15.1% of the borrowing price support. If interest rates move back to their 37-year mean of 8%, 26.8% of the borrowing price support is removed from the market.

Do you realize that prior to 2002, mortgage interest rates had only been under 7% one time in the previous thirty years? It hit 6.9% in 1998. During our last interest rate cycle during the wild credit expansion of The Great Housing Bubble, the peak did not reach the previous 30-year low.

Mortgage Interest Rates, 1972-2006

I think it is very reasonable to assume mortgage interest rates will move higher, perhaps much higher.

Are you comfortable buying with that much of the price support is air from the Federal Reserve?

Downpayment Requirements

Downpayment requirements have traditionally been very high. During the 1920s, interest-only loans with 50% downpayments were the norm. Very few people owned their houses. By the 1950s, conventionally amortized loans with a 30-year term and 20% downpayments became the norm, and house prices rose significantly from the bottom of the Great Depression to the 1950s due to the increased use of leverage in real estate.

That is the end of the road for financial innovation. All attempts to tinker with the stability of conventional financing have failed because they are all Ponzi Schemes. People must have a reasonable expectation of paying off a loan in their lifetime. Multi-generational debt is frowned upon here in the United States, so any term beyond 30 years really doesn’t make sense. If you feel like you will never pay it off, you will not try, and you fall into Ponzi thinking and borrow in terms of maximum debt service. It is crazy.

By 2005, Option ARMs and 100% financing left us with 0% downpayments as the cycle reaches its ultimate limitation — they are giving it away. Not surprisingly, prices skyrocketed; unfortunately, the terms of the Option ARM were not stable and the Ponzi Scheme blew up. We are back to the 1950s in the world of mortgage finance — that is a good thing.

The 30-year fixed-rate fully-amortizing loan is the only stable loan product, and a significant downpayment is required to keep down speculation. As downpayments get smaller, the incentives to speculate with lender money get larger. With no-money-down the incentive to speculate hits infinity. One-hundred percent financing with no qualification is a free-for-all no-limit housing market casino.

Savers gain advantage bidding on real estate.Biggest Saver

My calculations of value in the table at the top of the post assumes the downpayment added to the loan to obtain value is 20%. Irvine buyers are unique in that they put in very large downpayments. Most buyers don’t have 20% down. Most buyers don’t have the current FHA standard 3.5% down either, or we wouldn’t have tried 0% down to begin with.

When it is an FHA buyer — which 21.5% of buyers are again — they generally only put the minimum 3.5% down. The loan plus the downpayment is about 16.5% lower for an FHA buyer than it is for a conventional borrower putting 20% down, assuming both are qualified using the same income and same DTI.

In the real world, the conventional borrower is also utilizing a higher DTI ratio. Instead of being limited to the FHA 31% front end DTI, conventional borrowers are often allowed to go into dangerous waters with 32% to 38% DTI levels. This additional money put toward debt service makes for larger loans.

The borrower with enough cash to put 20% down has a significant bidding advantage over the FHA buyer. The lower downpayment amount and the smaller loan balance make FHA less desirable than conventional financing for borrowers looking to bid up prices. FHA financing can be looked at as training wheels for mortgage borrowers.

After some period of time in a normally appreciating market (if there is such a thing), the combination of loan amortization and home price appreciation results in home equity exceeding 20% of the resale value of the property. When there is enough home equity that a more expensive house than your own house could be purchased with 20% down using your equity as the downpayment, you cross a threshold; you have access to the higher DTIs, and you can borrow more money to take the next step up the property ladder — if you are willing to give up some disposable income to have the house.

In the end, it is not the highly leveraged that gain the upper hand in real estate, it is the savers. The real estate market will always boil down to loan plus downpayment. The more money you have saved, the greater your downpayment and the more you can bid to compete with others at your income level. The saver always comes out ahead.

4 EARLYMORN Irvine, CA 92614 kitchen

Irvine Home Address … 4 EARLYMORN Irvine, CA 92614

Resale Home Price … $1,150,000 WTF

Income Requirement ……. $214,077
Downpayment Needed … $230,000

Home Purchase Price … $900,000
Home Purchase Date …. 9/8/2008

Net Gain (Loss) ………. $181,000
Percent Change ………. 27.8%
Annual Appreciation … 13.0%

Monthly Mortgage Payment … $4,995
Monthly Cash Outlays ………… $6,430
Monthly Cost of Ownership … $4,820

Redfin Property Details for 4 EARLYMORN Irvine, CA 92614

Beds 4
Baths 2 full 1 part baths
Size 3,068 sq ft
($375 / sq ft)
Lot Size 6,270 sq ft
Year Built 1980
Days on Market 4
Listing Updated 10/22/2009
MLS Number S593193
Property Type Single Family, Residential
Community Woodbridge
Tract Ld

WOW! If you want Woodbridge, you have to see this home! Right across the street from Meadowpark Elementary, gorgeously upgraded and with an unusually large lot; it really doesn’t get any better than this! With 4 bedrooms, 2.75 bathrooms and a huge bonus room across the top of the 3 car garage, this floor plan is family friendly. The entire downstairs has been remodelled with new front door, gorgeous cherry wood built-ins in living room/dining room, all new kitchen with everything-granite counters, added built-ins in the kitchen nook and all new top-of-the-line stainless steel appliances. All new windows & doors throughout, updated paint colors, this home is move in ready! Add your own private spa in your huge back yard & this one is an all around, hard to beat Woodbridge FIND!!! Serious EQUITY seller has priced this home right at the last sale of a comparable home so don’t procrastinate because this one will go!

Serious equity seller? You mean a delusional flipper who only believes he has equity. Based on when he bought, he would be lucky to get out at breakeven. You never know with today’s market though.

50 thoughts on “Ownership Cost: Interest Rates and Downpayment Requirements

    1. IrvineRenter

      It’s Halloween week. Yesterday was the song “Spooky,” and today it is “Thriller.” I have “Witchy Woman” coming out tomorrow. I found some intresting images for that one.

      1. Fracture

        Don’t forget:
        Black Magic Woman – Fleetwood Mac / Santana
        Superstition – Stevie Wonder
        Dragula – Rob Zombie
        etc… fun theme week =)

  1. autox

    “The real estate market will always boil down to loan plus downpayment. The more money you have saved, the greater your downpayment and the more you can bid to compete with others at your income level. The saver always comes out ahead. ”

    The problem is once people save more than 20%, they don’t stay within their own income level.

    1. tonye

      Huh? Says who? There’s lot of long term owners who are way above that 20%. Even with refinances and HELOCs you’ll find many owners sitting on 50% equity to paid off houses.

      At some point, your reach a point where your mortgage payment is less than rental. Heck, we just did a refi to 5 1/8%. Our mortage with insurance and taxes is like at least 500 bucks less than renting. How much would a 2700 sq foot, 5b/3ba “9 year old” house rent for in TR?

      As IR said, the savers always win.

  2. cara


    Savers win, huh? Let’s think about that for a second. Suppose you save $25k/ year by renting instead of owning. And you do this for 8 years, and then buy with $200k down. Yes, during the saving time that money was liquid, which is great for financial comfort and security. But in order to translate into bidding out other buyers you STILL have to eventually put it all into real estate, just later rather than sooner. Sure you earned rather than paid interest on it, and by having smaller leverage your price point is less fickle-ly tied to interest rates, but if in the end you still have to retroactively assign that much of your income to real estate, have you really won?

    1. IrvineRenter

      You are assigning that much of your income toward housing whether your rent or own. The question is do you want to assign that much of your savings to own such a volatile asset?

      In our IHB reports, we always recommend a healthy cash reserve held in reasonably liquid investments outside of real estate. In reality, most people do go all-in when they buy a house, but we certainly do not recommend it.

      If you put some amount of your savings into real estate, and that money is producing either a cashflow benefit or providing an inflation hedge through appreciation, then you are getting a return on your money. As long as you do not put in too much, you can get a reasonable rate of return. I covered those issues in Investment Value of Residential Real Estate.

      BTW, I have the calculator up and running for you.

      1. cara

        If you continue to rent forever then you never have to assign any of your savings towards a volatile asset, and can use it all as reserves, so no buying and renting do not inherently put the same amount towards housing.

        The problem as I see it that saving does not get you out of this SoCal loop of paying way too much of your income towards housing. Whether you saved it up ahead of time, (out of income) or you borrow for next to all of it (out of income). It doesn’t escape the problem of having way too much of your net worth in your house.

        (thanks for the calculator, I’ll check it out!!)

        1. IrvineRenter

          I see what you are saying. The way out of the SoCal loop of paying too much of your income towards housing is a choice about quality of life.

          People can always decide on their own accord to put less than the allowed maximums toward housing and accept a lower standard of living in exchange for a lower housing cost. If you consistently make that choice, you will save money. When the time comes to “move up,” someone wanting to get out of the loop could refinance to a shorter amortization period and stay where they are rather than stretch again and again for the biggest most expensive house they can obtain. The crazy loop is a choice, or more accurately, it is a trajectory that results from a series of choices in housing over many decades. I want my trajectory to avoid crashing into a market mountain.

          1. tonye

            The way of the saver is to lock in the house payment and allow for inflation to eventually lift the cost of renting to above your mortgage payment.

            Granted, the 0% money down screwed that up, but with historic very low interest rates and depressed housing valuations (OK more like a return to normal), if you can lock up a payment that you can easily handle you can sit for 30 years and pay off your house.

            Again, it’s all in the monthly payment: mortgage vs. renting. Somehow I don’t think rents are going to drop 30% in the next five years in Irvine or anywhere West of the Santa Ana Fwy (except of course in Santa Ana proper).

            Of course, as a saver, I take the long look. To me the house is a place to live, raise my family, play my Frank Zappa, hold my 4000 LP collection, my Sony SL1000HF Super Beta Deck, my four channel reel to reel, assorted Marantz quad receivers, etc, etc… As my brother in law says: “You guys sure have a LOT of stuff”… 😉

            If I had to rent a place to hold my stuff I surely could not afford it (or rather, I would not want to pay it).

  3. Swiller

    Buy what you want and can enjoy, not what you can “get”. If you ENJOY your home, you will want to keep it.

    Actually, I would NEVER buy in this market with all the things I know about the Fed and crap in Washington. Renting is FAR superior to buying in Orange County.

  4. Lee in Irvine

    What’s The Fed (our caretaker) gonna do about this little problem? Look at all the home-debtors in this OC neighborhood. BTW, most of these homes are in the Yale loop. Tic, Tic, Tic

    10 Elderwood, Irvine, CA? – more info »
    Foreclosure: $524,000
    2 bed 2 bath
    “This property is a Pre-Foreclosure.

    11 Whispering Wind, Irvine, CA? – more info »
    Foreclosure: $830,000
    4 bed 3 bath
    “This property is a Pre-Foreclosure.

    34 Claret, Irvine, CA? – more info »
    Foreclosure: $371,000
    2 bed 2 bath
    “This property is a Pre-Foreclosure.

    61 Claret, Irvine, CA? – more info »
    Foreclosure: $352,000
    2 bed 1.5 bath
    “This property is a Pre-Foreclosure.

    42 Claret, Irvine, CA? – more info »
    Foreclosure: $389,788
    2 bed 1 bath

    18 Southsand, Irvine, CA? – more info »
    Foreclosure: $474,900
    2 bed 2 bath
    “This is an REO

    Misty Run, Irvine, CA? – more info »
    Foreclosure: $494,694
    3 bed 2 bath

    13 Longshore, Irvine, CA? – more info »
    Foreclosure: $720,000
    2 bed 2 bath
    “This property is a Pre-Foreclosure.

    1. Chuck

      Funny, 18 Southsand was featured on this blog about a week ago, and the main point was that it was refreshing that it was NOT a short sale or REO and that the mortgage debt was very low. Yet it shows up on your list as a $474,000 foreclosure….

    2. Geotpf

      Well, assuming there isn’t a second big crash due to all the pre-foreclosures finally becoming REOs and short sales all at once (a bit of an assumption, to be sure), you shouldn’t wait any further. According to Redfin, Irvine’s house prices are up by $19 a square foot from this time last year and up by $27 a square foot from the absolute low in early March. (Irvine condos have been basically flat along the bottom since March.)

      Of course, even at this (either permanent or temporary) bottom, renting in Irvine is cheaper than owning. Since there are high transaction costs in buying and selling a house but not in moving from one rental unit to another, I would buy now, but only if you plan on living in the same place for at least a decade or so, perferably until you die or at least you pay off the mortgage. Otherwise, rent on a permanent basis. Other cities are different, of course.

      1. Geotpf

        This comment was supposed to go under gman’s “I’m tired of waiting” comment below. Dunno why it moved up here.

      2. Eat that!

        See that’s the problem right there. “Plan on living in the same place for a decade or more”. That’s one reason why NOT to buy a home. Who wants to live in the same tiny condo or town home for 10 years or more. I say the H with that.

        1. Geotpf

          Makes sense to me. That is, if you find your dream home, go ahead and buy it. If not, renting probably makes more sense financially, IMHO.

      3. gman

        I’m pouting because I know that there’s likely going to be another leg down and my tax money’s being used to forestall that. Sigh.

        1. Lee in Irvine

          Doesn’t that make you feel warm and fuzzy inside.


          Just think, the incompetent federal govt is now doing everything they possibly can to make sure you and I pay a bubble price for our Irvine home. They’ll even offer you an $8,000 tax credit if you do it now.

          1. matt138

            “It’s the least worse option.” ha ha. I love when people tell me that. It’s that rationale, over decades, that got us into this mess.

    1. irvine_home_owner

      I believe a .75 bathroom is sink/toilet/shower.

      1/2 bath is sink/toilet.

      1 bath is sink/toilet/bathtub.

      1. Geotpf

        Close, but a full bath should be sink/toliet/bathtub/shower. That is, each quarter of a bath is one plumbing fixture; a full bath has four fixtures, a 3/4 has three, a 1/2 has two. Not quite sure how you count a bathroom with a tub but no shower (not likely in Irvine, but they do exist in some older homes).

        1. irvine_home_owner

          Sorry… by “bathtub” I meant “bathtub w/ shower” because as you stated, a bathtub without one is rare in most homes in Irvine.

          Nitpick award for geotpf today!

        2. irvine_home_owner

          Incidentally, there are .25 baths in Irvine. There are a few homes in the El Camino area that have a bathroom with just a sink. I found that strange.

  5. ConsiderAgain

    “Federal Reserve interest rate support is a major reason not to buy a home. When these supports are removed and interest rates rise to market levels, loans will get smaller and prices will go lower ….”

    That is the most astute observation of the year.

    The question is timing. And how much the time between now and whenever the government gets out of rate-support mode is worth to you.

    Assuming financial ability to buy is not a factor, one’s resolve to not support the bubble is currently being tested against the one’s desire to own a home.

    1. Barren_Irvine

      Good things come to people who are patient. Don’t you know “Patience is a virtue”. Not a whole of people have that virtue in today’s bubble market. I am waiting for 10 yrs and I sure am not going to do something stupid now; when judgment day is upon us…

      1. gman

        10 years and you’re not tired of waiting? You must be some kind of a monk. Getting to the point where 1/3 of your mortgage term would have been paid for at that point. Isn’t there just a point where if it meets your minimum needs and you can easily afford it, you should just take the plunge?

        1. Geotpf

          I think a lot, again, depends on how permanent your plans are. If your job and life situation is such that you plan on never moving again, go for it. If not, renting is probably best.

          (Unless you live out in the sticks, like in Riverside (where I’m at). Then go ahead and buy no matter what. The math heavily favors buying out here, opposite of Irvine.)

  6. Sue in Irvine

    Another house near me that I know. I watched them fix it up last year. Then they had a for lease sign out and someone was living there. Recently I saw the for sale sign. So did the previous owner remodel and then the flipper bought it? I’m thinking that’s the case.

    1. IrvineRenter

      This whole week is Woodbridge properties. Only today is not a short sale, but I found it interesting because the seller is dreaming.

      1. Lee in Irvine

        I think there are opportunities to flip right now, but doing it at this time in Irvine California isn’t very smart. There are so many better opportunities, that are much less risky than betting on a $900,000 Irvine flip. I don’t think it’s smart to try to flip anything in white collar Orange County right now … and then trying to do it with something that’ll likely require financing outside of the govt’s backstop is just stupid. Oh well … JMHO … but I’ll follow this property to see how things work out.

  7. Eat that!

    The problem as I see it, is we are up against a wall. A classic liquidity trap. If we pull out the tax credit, the housing market will crash. If we raise interest rates, the housing market will crash. If we stop propping up failed banks, then they’ll have to dump their inventory, the housing market will crash. If we don’t keep the patient on life support, he’ll crash. There’s no easy way out of this scenario, until someone pulls the plug for us (i.e. the dollar crashes).
    The sucky part is, I make more money and I don’t get any tax benefits for being prudent and waiting out a very sick housing market. In fact, I’m punished for it, getting less interest on my savings and being placed in a higher tax bracket.

    1. matt138

      Housing – check mate, Dollar – check mate. Please tell me your savings are in other currencies.

  8. Sue in Irvine

    11 Whispering Wind is right around the corner from this house. The map has the street as Whisper Circle, which is wrong.
    I seem to recall 11 Whispering Wind listed a few months ago at 1.25 million. If this is the same house it’s comparable to today’s house.

    1. Sue in Irvine

      This was meant to go under Lee in Irvine list of nearby homes. 11 Whispering Wind is on his list.

  9. irvine_home_owner

    I’m not sure if $1.15m for a 3000sft Woodbridge house is delusional.

    Remember the blog entry for the equity sale of the Woodbridge house that low-listed for $869k? It recieved multiple offers over $1mil and closed at $1.13m earlier this month.

      1. irvine_home_owner

        But is it a delusion if it’s the current reality?

        Granted, most of us know the difference but that’s why non-fundamentals are usually the suspect in real estate valuation.

  10. Craig

    Isn’t the real danger of rising mortgage interest rates that they will trigger a humongous new wave of mortgage defaults from everyone with adjustable rate mortgages? Many people figured they could sell the house before the reset, but now they have no equity and no way out. If the only options are locking in at unaffordable fixed rates or walking away, guess which one wins….

    1. Geotpf

      Rates would have to rise a lot for this to be a problem, unless people are buying today with a variable interest loan, which is amazingly stupid considering that rates will probably never be this low again during our lifetimes.

  11. newbie2008

    The way I see it, the laws favor the non-saver with low to no money down.

    Case #1: Responsible traditional “homeowner” uses 20% down on over price house that was bid up by “new generation homeowners” and then must sell at 20% reduction because of relocatioin. The low to the homeowner will be the whole 20% down plus cost of house sale.

    Case #2: New generation “homeowner” Purchase over priced house with 0% down and then must sell because of relocation. Buy new home with with 3.5% down, and then walk away from first home. No cost for sale of first home. The first and second home can be bid up to almost any price without significant loss to homeowner.

    Radio ad this morning with financing of 125% equility at 4%. Buying down the interest with the money above 100% equity? Looks like bad habits are hard to break, especially when the govt. is encouraging them.

    Lee, Q: What’s the caretaker going to do? Answer: Kick the can down the road, and let your children and grandchildren pay for the mess.

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