QUESTION
I am the CFO of a mid-sized mortgage lender. We originate mortgages in 36 states. I am concerned about the impact that inflation has on mortgage banking. The tariffs are gradually driving up inflation, and economists predict a significant rise over time.
I am concerned about being prepared for inflation's effects on mortgage lending. I'm sure we can prepare for inflation. But my question is about the impact and the signs to look for. Thank you for considering this question.
What is the impact of inflation and tariffs on mortgage rates?
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ANSWER TO YOUR QUESTION
You ask a good question. Often, mortgage originators focus on interest rates, and with good reason. Inflation indirectly increases mortgage rates by prompting central banks to raise interest rates to slow the economy, which in turn leads to higher monthly payments for new and adjustable-rate mortgages (ARMs).
When rates rise, homebuyer affordability declines, and while fixed-rate borrowers are protected from future hikes, their new loans will have higher initial costs. For existing homeowners, high inflation can impact their decision to refinance, while low inflation may encourage them to lock in lower rates.
I think you are correct to tie tariffs to interest rates. Tariffs can negatively affect mortgage lending by raising interest rates and increasing monthly payments, thereby reducing housing affordability. This is because tariffs can increase inflation, prompting central banks to raise interest rates, and can also cause market instability and reduce demand for U.S. debt, further pushing Treasury yields and mortgage rates upward. Additionally, tariffs on construction materials raise home prices and can lead to more volatile application volumes and tighter underwriting standards for lenders.
CREDIT MARKETS
While many people monitor equity indices, I keep an eye on credit markets. In my view, the credit indices tell me what is really happening in the economy. Credit is a crucial component of the financial system, influencing everything from individual finances to broader economic trends and serving as an indicator of economic health. So, while others look at stocks and other equity instruments, I look at the primary, secondary, public, and private credit markets.
Prevailing interest rates are a key indicator of the health of the credit market. The level of investor demand also signals market conditions. And, the difference in interest rates between different types of bonds, like government bonds versus corporate bonds, can indicate economic risk. A widening spread can signal that investors are viewing corporate bonds as riskier, possibly foreshadowing a recession.
So, let's dig deeper into the impact of inflation on mortgage banking.
INFLATION
When inflation is high, the Federal Reserve may increase its benchmark interest rate to cool the economy. This directly leads to higher interest rates on new mortgages and can increase the monthly payments on existing ARMs. Higher interest rates and home prices make mortgages more expensive, reducing a borrower's purchasing power and forcing them to buy smaller or less expensive homes. High inflation might prompt some borrowers to take out an ARM with the expectation that rates will fall, enabling them to refinance later.
A fixed-rate mortgage offers some protection. Once a fixed-rate mortgage is secured, the interest rate will not change, even if inflation continues to rise. In a high-inflation environment, a fixed-rate mortgage taken out at a lower rate becomes more valuable compared to new mortgages with higher rates.
Thus,
refinancing becomes prevalent. If inflation is high and rates are rising,
homeowners with existing fixed-rate mortgages may be hesitant to refinance, as
new loans will have higher rates.
And when inflation is low and interest rates are lower, more homeowners may look to refinance their existing mortgages to lock in a better rate.
The relationship between inflation and mortgage rates is complex and influenced by monetary policy, global economic factors, and lender expectations. This aspect of the real estate cycle suggests that, instead of waiting for rates to drop, potential homebuyers consider their long-term needs and purchase a home, with the option to refinance later if rates decrease.
You are correct to be concerned. To sum it up, inflation typically leads to higher mortgage rates, which can reduce borrowers' purchasing power and make mortgages more expensive. However, it can also benefit existing fixed-rate mortgage holders, who repay their loans with money that has less purchasing power over time.
However, for lenders, inflation raises interest income on new loans but also introduces greater risks. When inflation is high, central banks, such as the Federal Reserve, raise the federal funds rate to reduce spending and stabilize prices. This causes lenders to increase their mortgage loan interest rates. As interest rates rise, government bonds become more attractive to investors. This reduces demand for mortgage-backed securities, which, in turn, leads to higher mortgage interest rates. Therefore, lenders raise interest rates to compensate for the fact that the money they will be repaid in the future will have less purchasing power.
The cycle has fault lines because, although lenders can charge higher interest rates on new loans, increasing their income and profitability, if inflation outpaces borrowers' incomes, they may struggle to make their mortgage payments, increasing the risk of default for lenders. That erodes repayment value because, despite higher interest rates, the real value of the money lenders receive over the life of a loan is reduced by inflation. The overall effect of the erosion can cause a market slowdown due to the fact that very high borrowing costs can slow down the housing market, since some buyers are priced out. Consequently, the inflation leads to a decrease in overall lending activity.
TARIFFS
Tariffs tend to impact mortgage lending through their effects on housing markets and, by extension, mortgage lenders. Taking a broad view, tariffs on materials like lumber and steel increase the cost of building and renovating homes, which can lead to higher prices for new and existing homes, reducing affordability. The combination of higher home prices and higher mortgage rates makes housing less affordable for many potential buyers, particularly first-time buyers with limited savings.
Affordability issues and market uncertainty consistently undermine demand and sales. A slowdown in buyer demand tends to lead to delayed purchasing decisions. Lenders then tighten underwriting standards. They may need to adjust their underwriting standards and debt-to-income requirements to account for higher costs and potential risks, as economic uncertainty created by tariffs leads to volatile application volumes.
Credit markets are generally wary of tariffs, and lenders should be concerned that they affect mortgage lending by creating economic uncertainty, leading to mortgage rate volatility and rising home construction costs, both of which are negative factors for housing affordability.
INFLATIONARY EFFECT OF TARIFFS
Over several decades of following the credit markets, I have found that the immediate market reaction to tariffs can sometimes cause a temporary drop in mortgage rates, driven by investor behavior. Nevertheless, the effect of tariffs on mortgage rates can be unpredictable in the short term, but the long-term trend is typically upward.
When tariffs are first announced, they create economic uncertainty, which can prompt investors to shift their money from riskier assets, such as stocks, to safer U.S. Treasury bonds. This increases demand for bonds, driving up their prices and lowering their yields. Because mortgage rates typically track the 10-year Treasury yield, they can also decrease temporarily.
The long-term inflationary effect of tariffs can lead to higher mortgage rates. Tariffs are essentially a tax on imported goods, including construction materials like lumber, steel, and aluminum, which increases their costs. Rising material costs and broader inflation can prompt the Federal Reserve to raise interest rates to cool the economy. In turn, this leads to higher bond yields, which push long-term mortgage rates upward.
Tariffs exacerbate existing housing affordability issues by increasing construction and renovation costs. New tariffs on building materials raise construction costs for builders. These additional costs are often passed on to homebuyers through higher sales prices. Recently, I checked the cost increases of building a new home. One estimate I checked projected that, thus far in 2015, tariffs could increase the cost of building a new home by over $9,000. I think that's on the low side!
When home prices rise, buyers need higher incomes and larger down payments to qualify for a mortgage. For many potential buyers, especially first-timers, these combined factors can price them out of the market entirely. Inevitably, there is a shift in underwriting. With affordability stretched, mortgage lenders may tighten underwriting standards, such as debt-to-income ratio requirements, particularly in markets most affected by cost increases. Eventually, decreased construction activity results, since higher construction costs tend to deter developers from starting new projects, slowing the supply of new housing and driving up prices for existing inventory.
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