Walking On Thin Ice
Most would agree the stock market, company valuations and real estate values have seen a historic increase in recent years. This increase has created a huge amount of wealth that otherwise may not have existed. This wealth has enabled businesses and individuals to buy new cars, fund college accounts, re-invest in the market and upgrade their homes. This historic run follows a recession with under-valued assets and practically free money to re-invest through low interest rates resulting in strong consumer confidence in the economy and the creation of new technologies and industry: social networking, big data, and mobile apps. This euphoria may seem never-ending, but it is sensible to be cautiously optimistic. If you had to walk across a frozen lake, you would be unable to recognize which sections had robust ice safe for walking and those fragile areas of thin ice. At afar, it appears the same, but a miss step could cause harm. Similarly, we are in a climate that appears to be robust and stable with companies being purchased for billions of dollars and a stock market up over nine percent for the year, though there may be sections of thin ice: sections in the market that seem to be stretched, a state of over-exuberance or just high risk opportunities enabled by the low cost of borrowing.
Even if we agree that there are sections of thin ice, what would be the effect once it cracks? For real estate, we have seen double digit growth over the past several years coming off the financial crash and we are seeing an abundance of cash being used to purchase properties. How will an interest rate increase affect this situation? I pose this question to many and I often hear people argue that the interest rate increase on mortgages won’t affect the market because so many buyers are cash. But what is enabling the bountiful plenty of cash? I argue a large percentage has been created by new wealth. The lower the interest rate, the more willing people are to spend and borrow and banks tend to loosen their lending guidelines to get money in circulation. In a low interest rate environment companies are more bullish on investing causing an increase to valuations and more purchases of smaller companies resulting in higher stock values. That value is then recognized by those who hold the stock, which is then sold at high values, resulting in lots of cash to buy their new home. When the interest rate increases so will the cost of borrowing across the global economy. The higher carrying costs will be felt by companies and families alike; companies will be less bullish to buy your company for a billion dollars and spending will decrease causing earnings and stock prices to drop. Wall Street may move to more conservative investments and you may be less likely to borrow as much, all because the cost of borrowing is higher.
Currently families seem to be stretching their purchasing power with the low interest rate environment. Banks have been aggressive on the debt-to-income percentage allowed because of the low rates, however, as they increase, so too will their guidelines and the days of 43% DTI ratios will go on vacation.
When the rates increase their monthly costs are higher resulting in a lower amount that can be borrowed; the decrease is approximately 10 percent per percentage increase. At that point families must: 1) put down more cash to offset the increased cost of borrowing, 2) buy a lower price property to keep the net monthly cost the same, 3) wait for prices to lower to keep monthly expenses similar. There is not one answer since no one knows how fast or much interest rate will increase and if there will be an impact on home values. Maybe the market can withstand the higher rates and prices keep appreciating at a similar rate. However, If you buy with a low interest rate with a higher price, the monthly costs could be lower or vice versa. There is generally a 12-month delay in the economy, meaning it will take about a year to see the effects of any significant increase or decrease of interest rates.
So are you thinking about buying or selling? What should you do? Since no one can time the market, I think it is important to strategize the various scenarios for your family and work through each option. If you are thinking about selling, we should discuss the target buyer and determine the best timing and home preparation to maximize that potential. If you are thinking about buying, we should discuss your finances, long term family plan and the various scenarios that could play out in the market. This strategic planning will help to understand the options and possibilities, so that you will be as prepared as possible. It is reasonable to hypothesize that any market correction could include continued strong employment, confidence in jobs and the economy, while experiencing slowdown in house prices because people may simply sit on their cash if they think real estate values are softening.