Friday, May 31, 2013

Interest Rates and their Effect on Real Estate

So apparently, it seems that the market is heating up.  Prices are on the rise (or so the media does report), but they tend to only report averages and that may not be applicable to your particular market focus areas.  The best thing to do is keep track of sales prices in your area.  Finding recent sales prices in your market is very easy compared to just a few years ago.  This will help you obtain market trends for your area and give you a focus rather than listening to the "averages" being thrown out there by the media.

Record low interest rates are allowing more qualified buyers into the market and the perception that prices are on the rise is really a good thing for the economy and it may well turn out to be a self-fulfilling prophecy.  Time will certainly tell....

Be on the lookout for higher interest rates on the horizon, but in my opinion, those are still far away.  I am not a fortune teller but through deductive reasoning, it follows that with the economy on the whole still not functioning on all cylinders with unemployment much higher than anyone wants, large interest rate increases are not coming yet.  Interest rates will however rise as a necessity to cool off an increasingly heated economy when that begins to happen but also to allow the government to pay down debt with lower cost dollars.  Because interest rates are so low now, a 1% rise in rates now will have a significantly higher impact on affordability than a 1% rise if interest rates were higher.  Let me explain (numbers rounded for ease of viewing):

Example A

On a $100,000 loan at 4%, the monthly payment is = $477 5%, the monthly payment is = $537         

% payment increase = $537 - $477  = 0.12576 = 12.58%   

Example B

On a $100,000 loan at 14%, the monthly payment is = $1,185
................................15%, the monthly payment is = $1,264

% payment increase$1,264 - $1,185  = 0.06666 = 6.67%    

Notice immediately that a 1% interest rate hike in Example A has a substantially higher impact on the monthly loan payment as a percentage than it does with the same hike of 1% in Example B.  It follows that as interest rates rise, a 1% rate hike will have less and less impact as a percentage on the payment.  Yes the payments are higher as interest rates rise, but the impact as a % is less as rates rise.  Conversely, when interest rates go down, the impact on the monthly loan payment is substantially higher.

Those homeowners and commercial property owners that are "betting" on low interest rates to make ends meet are potentially going to be shocked as interest rates rise because of the mathematics shown above.  Taking action to manage your real estate holdings to ensure that interest rates do not hurt you is very important at this time more than perhaps ever before.

On another general note, as a percentage of GDP, although the US National Debt is considered high by just about any observer, it is not as high as it was at the end of the second world war (see article)  I am simply presenting this information as a reflection of ratios and not total dollars because in my view, ratios tell the story better than total dollars owed.

Low interest rates are great if managed properly and by making provisions for interest rate increases that are definitely on the horizon, we can make the transition to a higher interest rate climate with less difficulty.

Until next time.....