As the country continues to deal with the economic pain and uncertainty that has accompanied the COVID-19 pandemic, interest rates and their impact on the recovery seem to be in the news constantly. To help real estate investors understand exactly what interest rates are, and how they impact their businesses, BPInsights is taking a deep dive on all things interest rates for this month’s feature.
What is interest?
Let’s start from the very beginning. The first part of this article is going to get into the details of what interest rates are and how they are determined. If this is overkill for you, feel free to skip to the next section, where I’ll discuss how interest rates impact real estate investors. That said, I’d recommend you read this section. To be an informed investor, it’s very helpful to understand the macroeconomic factors that impact your portfolio.
Interest is the cost associated with the borrowing or lending of money. When you borrow money, you pay interest to the lender as a fee for borrowing money. When you lend money, you receive interest from the borrower as a payment for lending them money. Interest is the cost of lent money.
Interest rates dictate the size of the fee. The higher the interest rate, the more total interest is paid on the loan. Interest rates are applied to all sorts of things, from credit cards to student loans to mortgages. For the purposes of this article, we’re going to be talking about interest rates in the context of mortgages and other forms of real estate financing.
To see how interest rates actually work in practice, let’s review the basic anatomy of a loan.
Every loan has four primary components.
- Principal: The amount borrowed (let’s use $1,000 as an example).
- Interest rate: The fee charged by the lender to the borrower. This is usually displayed as a percentage per year. Let’s use 3% per year for our example.
- Term: The length of any loan (we’ll use three years).
- Interest: The total amount paid by the borrower, to the lender, as a fee for the loan.
Using just these inputs we can calculate the cost of a simple loan.
- Interest = (principal * (1+interest rate) ^ term) – principal
- Interest = $1,000 * (1+.03) ^ 3 – $1,000
- Interest = $60.90
In this example, the cost of borrowing $1,000 for three years is $60.90.
Using this simple example, it becomes clear that the higher the interest rate, the more interest the borrower pays. If the interest rate were 4%, the borrower would have paid more for their loan. If it were 2%, they would have paid less.
As real estate investors we like low interest rates. Low interest rates mean it costs us less to borrow money for our deals. Lower cost of borrowing usually means better returns.
We’ll get into this in much more detail later on, but just take a look at this chart that shows the different amount of interest paid on two different mortgages of the same size ($240,000 principal).
At 5% interest, borrowers pay a total of nearly $224,000 over the course of the 30-year mortgage term. At 3.5%, the total interest paid is about $148,000—$76,000 less! Like I said, interest rates matter.
Who sets interest rates?
The interest rates you encounter as a real estate investor are the result of a complex set of factors that starts with the federal government and ends with your individual application. We’re not going to get into every single detail of this here, but I will provide a high-level overview of some of the primary drivers of interest rates.
You might be accustomed to hearing something in the news about “The Fed” raising or lowering interest rates. This type of news has become more mainstream recently, particularly in response to the COVID-19 pandemic and the related economic crisis. And while this process seems very far removed from your mortgage application, this is actually the primary basis for mortgage rates.
The Federal Reserve (the Fed) is the central bank of the United States and has many functions related to maintaining a healthy economy. One of the primary roles of the Federal Reserve is to set interest rates. This activity by the Fed does not directly impact consumer mortgage rates. Instead, it sets how much it costs banks to borrow money (both from each other and from the Fed itself).
The Fed’s interest rates come in the form of a target range. Right now, that range is 0-.25%. Because banks are private institutions, they have some ability to determine their actual interest rate within the Fed’s range. As of the writing of this article in February 2021, the actual rate at which banks are borrowing from one another is about 0.08%.
All that can get a bit complex, but the main point is the Fed controls how cheap or expensive it is for banks to borrow. When the Fed interest rate target is low, it’s cheap for banks to borrow. When the Fed interest rate is high, it’s expensive for banks to borrow.
This number—what a bank pays to borrow money—really does matter. If it’s cheap for banks to borrow, they can make loans at low interest rates and still maintain their profits. When a bank has to pay high interest rates to borrow, they pass along those high interest rates to their customers.
While adjustable-rate mortgages (ARMs) and home equity lines of credit (HELOCs) are closely tied to the Fed’s rate, the most popular mortgage, the 30-year fixed mortgage, is more closely tied to the yield on Treasury bonds (which are impacted by the Fed interest rate too). We’re not going to get into that here, but here is a good article that explains it in some detail.
What is important for you to understand is that the actions of the federal government set off a chain reaction that winds up with a range of mortgage rates that lenders offer consumers. Where your loan falls within that range depends on the details of the loan, your credit score, loan amount, type of investment, and more.
How does the Fed set their target?
All of this raises the question: How does the Fed determine its target interest rate?
The answer is both simple and complex. The simple answer is the Fed sets its interest rate in a manner it believes is best for the long-term health of the economy. Of course, that has many complex factors like wage growth, job growth, the stock market, the housing market, inflation, and much more. But really, the Fed has one job: manage the economy.
Changing interest rates is one of the best tools the government has to manage the economy.
When times are good, the Fed typically raises interest rates. The thinking is, “Things are good! Banks and consumers can afford to pay higher interest rates right now because the economy is humming, earnings are up, and unemployment is low.”
This keeps the economy from overheating and ensures that there is an appropriate supply of money in the market. If rates stay low during an economic expansion, it can lead to an oversupply in money which can lead to asset bubbles and subsequent crashes.
When times are tough or uncertain, like they are now, the Fed typically cuts interest rates. This incentivizes banks to make cheap loans. Cheap loans to businesses, real estate investors, or even individuals keep money flowing in the economy. The thinking is, “During uncertain times people typically save their money instead of spending it. Reduced spending hurts the economy further and can lead to a downward spiral with an undersupply of money in the economy. If we lower interest rates, people will take advantage of inexpensive loans, spend money, and revitalize the economy.”
One of the proven ways out of a recession or a depression is to spend your way out. We saw this after the Depression with the New Deal and after the Great Recession through various stimulus efforts. The government can generate spending with things like stimulus and infrastructure projects, but the best way to encourage spending in the private sector is to lower interest rates.
Where are we now?
Now that we’ve covered what interest rates are and where they come from, you’re probably wondering what interest rates are today. It’s a good question, with a good answer for real estate investors: They are historically low, and close to the lowest they are ever likely to be.
This is not an exaggeration. Interest rates are near the lowest they’ve ever been in history, and the lowest they are ever likely going to be.
How do I know this? The Fed interest rate target is currently set to 0-0.25%. It’s pretty hard to set an interest rate lower than zero! The Fed has done its part to make loans as cheap as possible across the entire financial system.
(Note: It is actually possible to have interest rates below zero. Some governments, most notably in Europe, set negative interest rates during the recovery from the Great Recession. This means that banks are actually paid to borrow money! While this is always a possibility, it is unlikely to occur in the United States.)
Remember when I mentioned that mortgage rates are also impacted by the yield on a 10-year Treasury note? Well, those are near historic lows too. They bottomed out last summer and are starting to climb, but still remain extremely low.
Basically, the economy is creating a perfect situation for low mortgage rates, and mortgage rates have indeed fallen to historic lows. The Fed rate near zero, plus Treasury note yields near their historic lows is precisely the scenario needed for rock-bottom mortgages. Check out this data from the Federal Reserve Bank of St. Louis.
Mortgage rates are the lowest they’ve ever been. This chart only goes back to 1971, but let me say this again: Mortgage rates are just about the lowest they’ve ever been, and it’s unlikely they’ll ever be lower than the rates we’ve seen over the last year or so.
Personally, I think interest rates will stay low for at least another year. That is, at least the Fed’s target will stay near zero for 2021 in my mind. I am not sure if mortgage rates will stay this low because Treasury note yields are slowly rising, but I think mortgage rates are going to continue to be very favorable for the foreseeable future.
How do interest rates impact real estate investors?
As you probably already know, interest rates have a significant impact on the real estate market and the returns on any given deal.
Low interest rates tend to drive increases in property prices. For real estate investors, this is usually a good thing!
Take a look at the graph below that overlays mortgage rates and the median home price since 1975.
Looks pretty clear to me that when mortgages decline, home prices rise. If you’re thinking, “You need to factor in inflation!” you’re right, we do. To do that, I created the same graph with the Case Schiller Index, which accounts for inflation.
To further prove the point, and because BPInsights is all about data and statistics, I looked at how these variables are correlated.
Quick math class refresher: Correlation measures the relationship between two variables and is measured on a scale between -1 and 1. A correlation of 0 means there is no measurable relationship between the two variables. A correlation of 1 is a perfect positive correlation and means that when one variable goes up, so does the other. A negative number still indicates a relationship between the variables, but means that when one variable goes up, the other goes down. Remember, correlation does not mean causation. One doesn’t necessarily cause the other, it just means they have a relationship to one another.
When I measured the correlations in the charts above, I got -0.84 for median sale price, and -0.82 for the Case Schiller. Those are strong negative correlations. We can see this plainly with our eyes—and validate it statistically, too.
What then is the link between interest rates and home prices?
Affordability! Lower interest rates make it easier for home buyers (or investors) to buy more expensive properties. When home buyers have more money to spend it raises demand, which sends prices higher. Let’s look at an example.
Jeff is a first-time home buyer. He wants to buy a home to live in and has a budget of $1,500/month. With interest rates where they were before COVID-19, Jeff could get a mortgage at a 4.5% interest rate. Given his budget, that means Jeff could afford a house that costs about $370,000.
With interest rates at the point they are now, Jeff can get a mortgage at a 3% interest rate. Given the lower cost of his mortgage, Jeff can now afford a $455,000 house!
Jeff’s new spending power means he can afford to look at more expensive houses and that sellers can raise prices to match increased spending power. This causes housing markets to heat up, as we’re seeing in almost every market across the United States right now. Cheap debt (low interest rates) is fueling massive price appreciation.
Just like home prices, lower interest rates are negatively correlated with higher rents (-0.84). For this I used the Bureau of Labor Statistics’s Consumer Price Index for Rent of Primary Residences. And from this chart you can see two striking things:
- Rent does not stop going up.
- The dramatic rise in rent increases over the last 45 years has corresponded with a dramatic decline in mortgage rates during the same period.
Why is this happening? I cannot say for sure, but my best take is that the explanation is pretty simple. Lower interest rates cause housing prices to increase. Because investors/landlords have to pay more for property, they pass those additional expenses on to tenants. When home prices go up, so does rent. My thought is that mortgage rates are not causing rents to go up. Rent growth is a secondary effect of mortgage rates’ impact on housing prices.
Regardless of causality, for our purposes as real estate investors, the main point is that lower interest rates don’t negatively impact rent growth, and possibly benefit rent growth.
How interest rates impact returns
Time to put this all together and examine how interest rates actually impact a real estate investor’s bottom line.
For this example we’re going to look at how interest rates impact the returns on the following purchase:
- Purchase price: $300,000
- Down payment: 20% or $60,000
- Mortgage type: Fixed Rate
- Mortgage term: 30 Years
- Rent/month: $2,500
- Non-debt expenses: $1,066
First, take a look at this table that models out both the monthly payments and the total interest paid over the lifetime of the loan for different scenarios.
At the top of the table, we have interest rates of about 5.5%—something we haven’t seen in about a decade, but when I got started in real estate investing in 2010, that was close to the historic low!
Now, it’s possible to get mortgages as low as, or even lower than, 3%.
Check out the difference between those numbers. For every half-point reduction in the interest rate, you would save between $66 and 75, which amounts to about a 6% reduction in your monthly debt service payments.
Looking at this impact over the lifetime of a 30-year mortgage is even more dramatic.
The difference between getting an interest rate of 5.5% and 3% is almost $125,000. Put another way, if you bought a property with a 3% interest rate, the total amount of interest you pay on your line is about half of what you would pay if your interest rate was 5.5%.
Let’s take this example one step further and plug these numbers into the BiggerPockets Rental Calculator and look at how cash flow would be impacted.
For this I used two scenarios: a purchase at a 5% interest rate and a purchase at 3.5%.
At 5%, we produce a positive cash flow of $195 per month and a cash-on-cash return of just over 3.6%.
If we held the property for the entirety of the loan, we would achieve an annualized return of about 8.8%, and would walk away from a sale with more than $750,000. Not bad, but let’s look at the type of returns we’d generate if we did the same deal with an interest rate of 3.5%.
In that scenario, we’d be producing nearly double the cash flow each month ($406 vs $195), and would have a much better cash-on-cash return of 7.5%.
At the end of our 30-year hold we’d walk with $827,000 in profit, good for a 9.1% annualized return.
At the end of the day, purchasing this property with a loan of 3.5% vs 5% leads to an additional $76,000 in cash flow and profit.
Hopefully this deep dive into interest rates has convinced you that interest rates really do matter. Getting the best possible interest rate will have significant impacts on your returns.
But many of you are still asking the question on many investors’ minds right now: Is now a good time to buy?
In my mind, the answer is clear if you’re investing for the long term. Yes, now is a good time to buy. Lock in historically low interest rates for 30 years and let market appreciation and positive cashflow do their thing for you for the long run.
Many people are worried that the market is overheated right now given how fast prices are rising in many markets. This is a legitimate concern. I cannot profess to fully understand the impact of the unemployment situation, mortgage forbearance programs, and eviction moratoriums on future housing prices. But I will say that I think a crash is unlikely.
Look at our earlier chart of the median home price over the last 45 years. There is only one period (following the financial crisis) where home prices dropped for a significant time. In that case, it took about six years for prices to return to their previous high. Even people who bought at the height of the market in 2007 have achieved, on average, 2% annualized appreciation over the last 14 years. It definitely was the worst time to buy in the last 20 years, but on the right time horizon, those folks still came out ahead.
I’m not saying there is no risk; there is risk in every investment. But for me, if you’re investing to set yourself up for the next 20-plus years, the benefits of locking in historically low interest rates outweigh the risks of a market correction.