Interest Rate Drop Brings Hard Choices

A three-quarter-point drop in mortgage rates over the past month, coupled with predictions that they could slide even further, is forcing some tough decisions on first-time buyers, homeowners and builders.

Experts say that most people trying to buy their first house should proceed with their plans, in part because any further drop in rates will likely be offset by rising home prices.

But homeowners who are considering “trading up” must think twice, or they may wind up buying a more expensive house just as price increases in the high-end market start to moderate, as some experts think they might.

“To buy or not to buy” is not the only question facing those pondering a move:

Consumers who decide to take the home-buying plunge must also decide whether to choose a fixed-rate loan at today’s relatively low rates, or take out an adjustable-rate mortgage in the hope of saving even more money if rates decline further.

And home buyers are not the only ones being affected by declining rates. Some home builders say the drop has already boosted foot traffic in their sales offices, but they’re hedging their bets by purchasing “insurance policies” against future rate increases.

“Interest rates have been coming down, and I think they’ll keep gently drifting down through the rest of this year,” said John Tuccillo, chief economist of the National Assn. of Realtors. “But if you’re in the market for a loan right now, all I can say is that there’s no easy answer as to what you should do.”

Interest rates dropped sharply last month after several government reports indicated that the nation’s pace of economic growth is slowing. A cooling economy eases inflationary pressures and, typically, pushes mortgage rates down.

Rates had been creeping up since last year amid signs that the economy was overheating. Fixed-rate, 30-year mortgages reached an average 11 1/4% in late March, according to the Federal Home Loan Mortgage Corp., but began falling and now stand at about 10 1/2%.

Introductory rates on adjustable-rate mortgages have dipped to about 9 1/4%.

As always, just how much more rates may drop--if at all--is a source of debate among real estate experts. But of the half-dozen economists interviewed for this story, only one said rates would move higher through the end of this year. Five predicted that rates would stay about where they are or drop another one-half to one-full point before 1989 is over.

A further decline in mortgage rates would be a double-edged sword for many buyers, especially those looking for their first home.

On one side is the obvious benefit: Lower rates translate into “cheaper” loans, making it easier for first-time buyers to get a mortgage and purchase a house. On the other side is the rise in home prices that lower rates usually fuel.

Many experts had predicted that price appreciation would slow dramatically this year, in part because higher rates and skyrocketing prices have pushed so many buyers out of the market. Fewer buyers were supposed to translate into fewer sales and softening prices--a classic supply-and-demand scenario.

But much has changed since mortgage rates started dropping in March, many experts say. Lower rates are keeping an unexpected number of buyers in the marketplace, so predictions of moderating home prices may not materialize until the end of this year.

“Price increases are having a far greater impact on affordability than interest rates are,” said Joel Singer, chief economist of the California Assn. of Realtors.

“When prices are going up 1% or 2% a month, you need an extremely large drop in interest rates to offset the impact of those higher prices,” he said. “We haven’t seen that kind of big drop in interest rates, and frankly, I don’t think we’re going to see it any time soon.”

For example, assume a buyer wanted to purchase a $120,000 home, modest by Southland standards. If the buyer made a 10% down payment of $12,000 and got a $108,000, 30-year fixed-rate mortgage at the going rate of about 10 1/2%, monthly payments for principal and interest would be about $988.

If prices went up just 1% monthly through the end of this year--again, a modest expectation in most Southland markets--the house would be worth about $128,700. A new buyer would then need to make a down payment of about $13,000 and find a loan at about 9 1/2% to keep monthly payments near the $988 level.

Mortgage rates haven’t been near 9 1/2% since the start of 1987, and no one seems to think they’ll drop that far soon.

“The longer you wait, the further behind you’ll get,” said Sam Lyons, senior vice president at Beverly Hills-based Great Western Bank.

Interest rates and appreciation potential aren’t the only factors concerning people who already own a home but are thinking of “trading up” into a more expensive house.

“You have to consider the rate on your current mortgage, your household needs, the appreciation potential in the neighborhood you want to move to and your own economic future,” said economist Singer.

For example, a homeowner who has an 8% loan may want to stay put because current rates are much higher. So might a homeowner whose earnings would drop if a recession takes hold this year or next, which Singer and most other economists say is a distinct possibility.

Hidden Cost Factor

These owners must also consider the hidden costs involved in moving up the housing ladder. An owner who sold a $250,000 home and traded up into a $350,000 house could easily wind up losing $30,000 of built-up equity to sales commissions, closing costs and other fees associated with both the sale and the purchase.

And it could take a long time for appreciation to offset that $30,000 in costs: Singer predicts prices in many Southland markets will be rising at about a 15% clip by the end of this year, down from the 20% to 30% rate of a year ago.

On the other hand, homeowners in desperate need of more space to accommodate a growing family or those whose current loans carry interest rates that are comparable to those being offered today may be more willing to move.

Consumers who decide to buy a new house must then decide what type of loan they should use to finance the deal. And increasingly, it looks like an adjustable-rate mortgage may be the best choice.

ARMs haven’t looked too attractive over the last several months because the difference between the introductory rate on ARMs and rates on fixed-rate mortgages has been small.

Taking on New Luster

Many borrowers have been choosing fixed-rate loans over adjustables, figuring the 1% or 2% higher rate they would pay for the security of a fixed-rate mortgage offsets the uncertainty involved with an adjustable loan whose rate can move upward with inflation.

But with many experts now saying that rates will fall this year and next, adjustable-rate mortgages are taking on new luster.

“I think rates could move as much as one point lower by the end of this year, and they’ll keep dropping at the start of 1990,” said NAR’s Tuccillo. “So if you take out an ARM today, your payments would drop right along with interest rates.

“You wouldn’t have that luxury if you chose a fixed-rate mortgage. But if I’m wrong, and rates go up, you could always refinance with a fixed-rate mortgage to protect yourself against further rate increases.”

Convertible mortgages are another attractive option for today’s home buyers, some experts say. Convertibles start out as an ARM with a relatively low introductory rate that is adjusted periodically, usually every six or 12 months.

Option to Convert

However, the borrower has the option to convert the loan to a fixed-rate mortgage during a specified period of time, usually between the end of the first year and the start of the sixth.

If rates head lower, the borrower can keep the rate adjustable and mortgage payments will drop. But if rates head up again, the homeowner can convert into a fixed mortgage to lock in monthly payments and avoid future rate increases.

The recent drop in mortgage rates is good news for home builders, who say the decline has brought back many of the buyers who were temporarily knocked out of the market when rates jumped earlier this year.

“Things slowed down in March, when rates really peaked,” said Bob Jones, vice president of Weston Development. The Los Angeles-based builder has two for-sale housing tracts open in Ventura County, with prices ranging from about $190,000 to $350,000.

“Now, many of the people who quit looking a couple of months ago are back in the market because the rate decline has made it possible for them to buy a home again. Foot traffic in our projects is up about 15% since rates started dropping in early May.”

Hedging Their Bets

Jones, like many other home builders, thinks rates will fall a bit further or remain fairly stable through the rest of this year. Yet Weston Communities is among the dozens of home-building companies that are hedging their bets against further rate hikes through a variety of methods.

Los Angeles-based Kaufman & Broad Home Corp., which concentrates on the entry-level housing market, has struck a deal with a group of lenders that guarantees its future buyers affordable loans.

The deal calls for lenders to provide up to $400 million in loans to buyers in more than two dozen K&B; tracts across the state. The buyers can choose a fixed-rate 10 1/2% mortgage or an ARM with an introductory 7 3/4% rate, even if rates shoot skyward later this year.

It cost Kaufman & Broad about $6 million to line up the guarantee, which is good only through the end of the year. And if rates drop, it will be $6 million down the drain because buyers will simply opt for the lower prevailing rates.

“Nobody likes to spend $6 million for nothing, but we consider the agreement an ‘insurance policy’ against future rate hikes,” said R. Chad Dreier, K&B;’s senior vice president and chief financial officer.

“If rates jumped up suddenly and we didn’t have insurance, a bunch of people would be knocked out of the home buying market and we’d get stuck with a bunch of empty houses. That would cost us a whole lot more than $6 million.”

INTEREST RATES DURING 1989 Average rates for 30-year fixed-rate mortgages available with a 20% down payment from U.S. lenders in 1989.

Week ending Rate Jan. 6 10.80 Jan. 13 10.81 Jan. 20 10.71 Jan. 27 10.60 Feb. 3 10.55 Feb. 10 10.56 Feb. 17 10.69 Feb. 24 10.78 March 3 10.91 March 10 10.86 March 17 10.98 March 24 11.22 March 31 11.19 April 7 11.07 April 14 11.11 April 21 10.99 April 28 11.03 May 5 10.97 May 12 10.93 May 19 10.69 May 26 10.50

SOURCE: Federal Home Loan Mortgage Corp.