Sunday, August 7, 2016

The Downside of Low Interest Rates

Ever since the US downturn in 2008, interest rates have been dropping both for savers and for borrowers. The upside is those with debts, who were able to refinance, enjoyed a greatly reduced cost of borrowing. Low interest rates made buying a home much cheaper and easier to qualify for.  Monthly payments are almost 50% less at a 3.5% interest rate than at a 7.5% interest rate. The reduced cost of buying a home has helped keep housing prices high in Hawaii, reduced foreclosures rates, and added to local governments’ funds with higher property taxes from higher real estate valuations.

If the US economy continues to improve and interest rates return to previous rates of 8% or more, what will the downside be of this past decade of ultralow interest rates be?

The most obvious downside is that house buying will be much more expensive. A monthly payment on a 30 year, $600,000 mortgage will go from $2308 at the current 3.5% interest rate to $4195 at a 7.5% interest rate.  A $2308 payment at a 7.5% interest rate would only buy a $329,714 home, a mere 55% of what the same payment buys at 3.5%. If the return to higher interest rates drops the home selling prices and ultimately the property values as you would expect, then these lower values will reduce income to local governments from  lower real estate taxes. It seems likely that foreclosure rates will also increase along with more people having underwater mortgages.

A similar calculation can be run on how stocks prices could be affected with increased interest rates. With low interest rates, stocks are far more attractive to people wanting to earn money on their savings. Most saving banks are paying only 0 .25% interest which makes stocks that pay 1% dividends look very attractive. Risky stocks that pay a higher dividend (2% to 4%) are attractive to people who may not normally be willing to take the risk. When savings banks return to paying 7% or more in interest, it will have a very negative effect on most stocks; normal savers and investors  will be able to get better returns without the risk. Companies have benefited by being able to borrow at lower interest rates and they have improved their returns as a result. When interest rates go up, stock prices could drop up to 50%.

As we study how rising interest rates may affect the prices of real estate and stocks, we can see why the Federal Reserve (which controls interest rates in the US) is so reluctant to raise them. The interest rates offered by banks are normally higher than the Federal Fund rates for mortgages and lower for savings. If they raise the interest rates too soon or too much, the results could be a sharp drop in real estate and the stock market causing a downturn in the US economy.


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