Friday, April 08, 2005

Higher mortgage rates to bite


Impact of higher home loan rates could be felt far and wide across the United States -- soon.

By Chris Isidore, CNN/Money senior writer

NEW YORK (CNN/Money) - Whether or not rising mortgage rates cool the housing market, they're going to put a multi-billion-dollar dent in consumer spending -- and soon.

That could have big implications not just for housing, but for U.S. economic growth, economists said.

Mortgage debt now stands at record levels, having risen $1 trillion last year alone, and dwarfing other types of consumer debt, like credit cards. Homeowners have turned the equity they have in their homes into a virtual ATM, supplementing their household cash flow through additional mortgage borrowing.

Mortgage rates are still relatively low -- about 6 percent for a 30-year fixed loan, according to financing firm Freddie Mac. But that's up almost a half a percentage point from just two months ago, and further increases are expected throughout the year by most economists. Mortgage rates are based upon sale of mortgage-backed securities, which generally follow bond yields, such as the benchmark 10-year Treasury.

Rising interest rates will not only raise monthly payments on millions of loans. It could close that ATM for many households unwilling to refinance again at higher rates. And without that ready source of cash, there will be less money to spend on everything from clothing to appliances.

Refinancing home loans has put an extra $300 billion a year in consumers' pockets in recent years, according to economists. Refinancing homeowners took the opportunity to borrow extra money to pay off credit-card debt, remodel or stock up on big screen TVs, dishwashers and other stuff.

That source of funds was crucial to supporting consumer spending, which stayed surprisingly strong despite a mostly weak job market the last four years, according to economists.

"It's a big number, it's about 4 percent of personal income," said Richard Brown, chief economist for the Federal Deposit Insurance Corp.

Such a large hit to income is almost certain to dent spending, which fuels more than two-thirds of the nation's economy.

Higher interest costs for many

Most home loan refis were at fixed rates, meaning homeowners don't have to worry about rising rates hitting their mortgage payments. But as rates started rising, refinancing dropped to less than half the levels seen at the peak in late 2002 and early 2003.

And with the refinancing "ATM" closing down, a record number of homeowners turned to home equity lines of credit to tap into the value of their homes. But unlike fixed-rate home loans, home equity lines have seen some of the steepest increases in rates since last June.

The amount Americans owe on home equity lines of credit jumped to about $491 billion at the end of 2004, up 42 percent from a year earlier, and more than triple the amount at the end of 2000.

Home equity lines are usually tied to the prime rate, which in turn moves in lock step with the federal funds rate, which the Federal Reserve has boosted seven times starting last June.

That means just the last two quarter-point hikes by the Fed will cost home equity borrowers about $2.5 billion more in interest this year. And most economists expect at least another full-point increase by the Fed this year, meaning another $5 billion in debt service for those consumers.

Growth of variable rate mortgages

While most home refis were at fixed rates, there are enough variable-rate mortgages out there -- just less than 20 percent of the $7.2 trillion in total mortgage loans outstanding -- for rising rates to be felt there as well.

Not all of the $1.4 trillion in variable-rate mortgages adjust every year. But a 1 percentage point rise in rates on only half of that loan portfolio would mean about $7 billion more in interest costs to those borrowers.

Many people with variable-rate loans used them because their income or credit ratings weren't strong enough to get a fixed-rate loan. While wealthier households might be able to absorb higher financing costs, people with variable-rate mortgages are probably on tighter budgets -- meaning they could be forced to cut back on their spending.

And with rising rates, the popularity of variable-rate mortgages are growing. Just above a third of the $2.6 trillion in mortgage loans written last year were at variable rates.

Slowdown soon?

Rising rates should start to hit consumer spending in a big way by this summer, according to economists.

"We definitely have to figure that once tax filing season is done and tax refunds are cashed, we do expect consumer spending will slow down in the second half of this year," said John Silvia, chief economist for Wachovia Securities. "I don't see any way to fudge that (higher financing costs). You're not getting the employment gains or wage and income gains to offset that."

Some economists said rising rates could force more belt-tightening for consumers than even record gasoline prices.

"People have gotten used to the fact that gas prices come and go," said Bob Brusca of FAO Economics. "If energy prices turn around, the impact will go the other way just as quickly. But the problem is the debt isn't going to go away."

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