Those looking to purchase a home, along with existing owners, may have come across the term “mortgage-rate effect” recently.
It’s a relatively new phrase that came about thanks to the extremely low mortgage rates that were available in 2020-2022.
During those years, it was entirely possible to cut 30 years in the 2-3% range.
In fact, some lucky homeowners may have gotten their hands on a mortgage rate that starts at 1.
Here’s the catch – now that prices have doubled, many of these homeowners don’t want to part with their lower prices. Or maybe worse, you can’t.
What is the effect of mortgage rate insurance?
In short, rate-fixing mortgage is a phenomenon where borrowers are essentially trapped in their homes thanks to extremely cheap mortgages.
It’s not entirely passive, assuming they like their possessions. But it has been referred to as “Golden Handcuffs” because it can be somewhat bittersweet.
Basically, people with mortgage interest rates pegged at 2-3% know they’ve got an amazing deal on their hands.
But if and when they sell, they lose out on that amazing price. Even worse, they will have to put up with a much higher mortgage rate if they buy another home and finance it.
In fact, the only way to avoid this situation is to sell and rent or buy and sell a home for cash.
Any other scenario essentially doubles the interest rate for the borrower, from the range of 2-3% to 6%+.
Not only is this medication difficult to swallow, but it also presents affordability challenges. Especially since housing prices have not fallen much.
Remember that there is no negative relationship between home prices and mortgage rates. Both can rise together, or fall together.
Despite the recent sharp increase in mortgage rates, there has clearly been some downward pressure on home prices, especially in areas of the country that have seen big gains.
However, because of this rate, the current housing supply is very limited and has kept house prices high.
Mortgage rates doubled after the Refi boom
As noted, 30 year pricing was flat in the 2-3% range a few years ago. It officially hit an all-time low during the week ending January 7, 2021, according to Freddie Mac.
At that time you could get a 30 year fixed term mortgage for 2.65%, actually less than that if you pay discount points. Or simply shop around for the best deal.
And that’s exactly what many homeowners have done. The so-called “pandemic mortgage refinance superboom” resulted in about 14 million new mortgages between the second quarter of 2020 and the fourth quarter of 2021.
According to the Federal Reserve Bank of New York, about five million borrowers have extracted a total of $430 billion in home equity through their refinancing. These are known as cash refinancing.
Another nine million have refinanced their loans without extracting equity and reduced their monthly payments in the process. This is known as the refinancing rate and term.
This has resulted in a staggering $24 billion reduction in total annual housing costs. And remember, that could be for the next three decades on these 30-year fixed mortgages.
And yes, fixed, meaning the interest rate doesn’t change, no matter what happens to the mortgages in the meantime.
Speaking of which, the going rate on a 30-year fixed is now close to 6.5%, according to Freddie Mac.
Can current homeowners afford to move?
Now trading in a mortgage at 2-3% versus one above 6% is clearly disadvantageous, especially if the price of the house hasn’t changed much.
This makes a lateral movement unfavorable, and a move up is unlikely to be bought.
Moving from one house to another is simply not cost effective. Let’s consider an example.
Let’s say you buy a home in 2021 for $500,000, put down 20%, and get a 30-year flat rate of 2.75%.
This brings the monthly principal and interest payment to $1,632.96. What a bargain!
Now imagine that you are sick of your home, or simply want to move for whatever reason. The house you love will cost $475,000. Prices have decreased slightly.
I put 20% down the line and ended up with a $380,000 loan, but now the mortgage rate is 6.5%. Ouch!
This brings the monthly principal and interest payment to $2,401.86. What dragged!
Your mortgage payment just increased by about $770, or 47%. Yes, you are reading this correctly. So not only are they a great deterrent to moving, but they’re also likely to be prohibitively expensive for some (or many).
This explains why so many homeowners today are basically the same Imprisoned to their current characteristics.
Either because it does not make financial sense to move, or because it is not possible to do so.
Literally some homeowners may not even be able to get approved for a home equity loan at much higher rates today.
But wouldn’t the effect of the mortgage rate peg end if rates fell?
Those who do not agree with this whole mortgage rate limitation would argue that life happens. People will move for a variety of reasons, regardless of a low mortgage rate.
While this is true, it is unclear how many people will move for these reasons. It may be a very small percentage of the total pie.
They also claim that over time there is a diminishing value of the low rate mortgage. After all, every time you make a monthly mortgage payment, you have one less at your disposal.
But remember, a 30-year fixed comes with 360 monthly payments. So this scenario will take a very long time.
What can put an end to the mortgage rate restriction is lower mortgage rates. Not necessarily 2-3% again, just something in the ballpark.
So maybe 30-year fixed rates in the 4% range would do that. It would be more palatable for a homeowner to swap a 3% rate for a 4.5% rate. And more affordable too!
You could argue that lower housing prices will entice people to move, but they will also have to sell in the process. It is not clear if they would like to get a haircut and lose their low price.
What is more likely is to rent out their house and buy another one if that happens.
This explains why homeowners hold their mortgages for so long. And why confinement can actually be such a wonderful thing.