WHAT DO INTEREST RATES “DO”?

Interest rates make it easier, or harder, to borrow money; they also make it easier, or harder, for lenders to make money.

There is an odd twist to the history of interest rates since the millennium.  When the Federal Reserve Bank (the “Fed”) under Alan Greenspan lowered interest rates in the early 2000’s, this led to some of the financial mayhem that ensued.  In particular, it was one of the contributors to a freewheeling increase in the price of housing, and to the ensuing crash in the housing market.  The explanation of this is straightforward:  a 1% drop in rates leads to (approximately) a 10% increase in buying power.  When rates dropped from 8% in the late 1990s to 6% in the early 2000s, buyers could purchase 20% more house with the same monthly P&I.  Theoretically, this should lead to a 20% increase in the average price of housing.  Unfortunately, it did not!  It led to a 40%-75% increase (depending on where you lived) and, eureka, everyone wanted to buy houses, flip them and get rich.

The odd part is that when the housing market “crashed” from 2006-2011, the cure espoused by Ben Bernanke’s “Fed” was to lower interest rates further – from 6% down to 4% (even dipping into the 3s for a stretch).

Lately, rates started to nudge up.

Keep in mind that the pendulum swings both ways:  just as a 1% decrease in the rate leads to a 10% increase in buying power, so, too, does a 1% increase in rates lead to a 10% decrease in buying power.

Ouch!

Depending on location, rates crept up ¼ to ½ percent in 2015 – not enough to get excited about - yet.  But, for the old-timers out there, remember rates being 9% and higher.  If rates go to 6%, buyers will lose 20% of their buying power.  If rates go to 8% (a “normal” interest rate, even a little on the low side for the old-timers), buyers will lose 40% of their buying power.

Here is the scary part:  does that mean housing prices will drop accordingly?  More (as they accelerated from 2002-2006)?  Or less (as the “Fed” hopes will happen)?

It is reasonable to assume that as rates start to creep up, more buyers will surface because they will want to buy before the going gets tough.  The interesting (pun intended!) part of the question is, when will higher rates slow down buying because rates went “normal”?

Janet Yellen wants to know the answer to that question.  And so do you.  My bet is 6 months after rates hit 4.5%, provided rates do not “dip” again.

How much will the market slow down?  How much will higher interest rates affect average prices?  Those are questions for economists and deep thinkers.  Let’s hope they are working on them.