Your home: Worst-case scenario
Will rising interest rates unravel all of the gains of the recent housing boom?
November 10, 2003: 11:46 AM EST
By Sarah Max, CNN/Money Staff Writer
BEND, Ore. (CNN/Money) - Interest rates are beginning to creep up again, and that could be bad news for homeowners.
The rate on 30-year fixed-rate mortgage loans rose to 5.98 percent in the week ended Nov. 6, and the trend could continue as a result of the rebounding economy and the deficit, which both have the effect of lifting rates.
For now, rates are at historically low levels. But John R. Talbott, a visiting scholar at UCLA's Anderson School of Business and author of "The Coming Crash in the Housing Markets," has a thesis that will leave you quaking from behind your picket fence.
He describes a worst-case scenario in which rising interest rates drive down home prices, leaving an alarming number of homeowners -- particularly those who've cashed out or borrowed against their equity -- holding more debt than their house is worth.
If they sell, they would actually owe money.
Under this scenario, foreclosure rates jump as high as 5 percent, pushing down home prices and wreaking financial havoc all the way to the top of the housing food chain at Freddie Mac and Fannie Mae. With the collapse of these financial behemoths, investors would lose money, taxpayers would be stuck paying for a bailout, and confidence in the banking industry would be as good as gone.
And your home? A 30 percent drop in home values isn't inconceivable, said Talbott.
"It's 1929 all over again," said Talbott, a former Goldman Sachs vice president. "This is big Depression-type stuff."
How rising rates affect home prices
To some, Talbott's theory sounds a little over the top. But considering the housing market's run, it's not unreasonable to think that fortunes could be lost just as quickly as they were made.
And though there's never been a nationwide decline in real estate prices, individual markets have suffered plenty -- see "Real estate horror stories."
Still, though most economists agree that rising interest rates will hurt home prices, it's tough to find one who thinks things will get quite so bloody.
Talbott contends that the relationship between rates and home prices is almost linear. In other words, a 30 percent increase in mortgage rates (from, say, 5.5 percent on a 30-year mortgage to around 7 percent) could mean as much as a 30 percent decrease in home prices.
The reason is the effect on a home's affordability. For example, a couple that could afford a $400,000 house when rates were less than 5.5 percent might only be able to pay $300,000 if rates go to 7 percent .
Others argue that the relationship isn't quite as direct. For one, when rising rates go hand-in-hand with an economic recovery, as they often do, better job prospects partially offset the effects of higher rates.
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