I’m sure I don’t need to remind anyone that our country is deep in a cost-of-living crisis.
Those with mortgages are struggling. Collectively we’re all having to tighten our belts.
And in the lead up to election day, our politicians are scrambling to come up with policies to support everyday Kiwis who are being stretched to their absolute financial limit.
And yet amidst all of this, New Zealand banks are thriving – bringing in record profits.
Banks margins have grown massively since the cost-of-living crisis began, by just over 15%. And every other week it seems, they’re pushing home loan interest rates still higher and higher.
People have rightly questioned how the banks can justify these ongoing increases, when wholesale interest rates have remained stable since the Official Cash Rate was raised to 5.50% on 24 May.
It’s why there’s a market study into competition in personal banking underway.
Taking a step back for a moment – let’s look at the facts…
Eighty per cent of New Zealand banks’ revenue is generated via what’s known as their interest margin.
That’s the difference between the interest they pay households and businesses on their savings, (or on what they borrow from the wholesale markets, including the Reserve Bank); and the interest they charge when they lend money out to homeowners and businesses.
The below graph tracks the banks’ interest margin over the last 32 years:
You’ll note that after trending downwards for decades, over the last two years – just as New Zealand’s cost-of-living crisis has emerged – that interest margin has grown rapidly.
Collectively, the banks have managed to expand their interest margin from 2.04% to 2.38%, which has equated to a roughly 17% lift in their overall profit margin on their lending. In just two years!
And on the $660 billion of interest-earning loans the banks collectively manage, it’s a whopping $2.24 billion of extra revenue they’re bringing in every year.
Or $43 million every week $6 million every day $0.25 million every hour $4,269 every minute Or $71 each and every second
So, what’s the driver behind what the banks are doing with home loan rates?
It’s actually not a what, but a who.
His name is Matt Comyn – and he’s the Chief Executive of the Commonwealth Bank of Australia, which owns ASB here in New Zealand.
In mid-August, he came out bemoaning the “unsustainable” returns the banks are having to put up with on loans within New Zealand’s housing market. Here’s the exact quote:
“The mortgage market in New Zealand is even more challenged [than Australia], where pricing conduct is difficult to reconcile. We’ve pulled back on volume growth in New Zealand given the unsustainable returns.”
Really? Cast your mind back to that graph we looked at earlier. The interest margins the banks are earning hardly look unsustainable to me.
Prior to joining Squirrel, I spent 30 years in banking, including four as Chief Executive of The Co-operative Bank, so I know a thing or two about how the banking system works.
When the banks set interest rates for deposits and loans, they’re not thinking about those rates in isolation – they’re thinking about what it means for their interest margin overall. That’s just Banking 101.
What happening here is a practice called price signalling
It’s extremely common in oligopolies, like the banking sector, where there are a few large players and extremely high barriers to entry.
Comyn’s comments were targeted at the major bank CEOs in Australia, and therefore indirectly at the four big Aussie-owned banks here in New Zealand.
The signal he was sending? “Our prices need to be higher”.
Then it just takes one competitor to lead the charge – in this case, it was ASB – so everyone else can follow suit.
And that’s exactly what’s happened in the weeks since.
Here’s how it’s played out with the popular one-year fixed home loan interest rate:
Using the wholesale one-year rate as the benchmark, the margin has lifted from about 1.0% after the last Official Cash Rate change on 24 May, to 1.5% now, on average across the big banks.
And we can also calculate the bank’s individual margins… At one end of the spectrum, we’ve got ASB earning 1.72%, and at the other we’ve got Kiwibank earning 1.26%.
I’d welcome a move by our Australian-owned banks to take a leaf out of Kiwibank’s book – and give New Zealanders a bit of a break.
Our banks have a social responsibility to do what’s right by New Zealanders – and right now, everyday homeowners are suffering, to bank shareholders’ benefit. At Squirrel, we see it day in and day out.
The average mortgage interest rate Kiwis are paying on our home loans has risen from 2.8% in 2021, to 5.3% now – on a $500,000 mortgage, that means $12,500 more in interest payments each year.
And with mortgage rates as they are now, that average still has further to climb to over 7%, and that would mean a further $8,500 in interest payments each year.
All without factoring in any further moves by the banks to expand their interest margin.
My challenge to our four big Aussie-owned banks is this: put your home loan rates back down.
A rate of 6.99% for the one-year fixed home loan term would be a good start. It’s time for our big banks to do right by Kiwis.
*David Cunningham is CEO of Squirrel, a mortgage broker that also offers peer-to-peer lending and savings and investment products and services.
Whoa, have you seen what just happened to interest rates!?
Suddenly, after at least fourteen years of our financial world being mostly the same, somebody flipped over the table and now things are quite different.
Interest rates, which have been gliding along at close to zero since before the Dawn of Mustachianism in 2011, have suddenly shot back up to 20-year highs.
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Which brings up a few questions about whether we need to worry, or do anything about this new development.
Is the stock market (index funds, of course) still the right place for my money?
What if I want to buy a house?
What about my current house – should I hang onto it forever because of the solid-gold 3% mortgage I have locked in for the next 30 years?
Will interest rates keep going up?
And will they ever go back down?
These questions are on everybody’s mind these days, and I’ve been ruminating on them myself. But while I’ve seen a lot of play-by-play stories about each little interest rate increase in the financial newspapers, none of them seem to get into the important part, which is,
“Yeah, interest rates are way up, butwhat should I do about it?”
So let’s talk about strategy.
Why Is This Happening, and What Got Us Here?
Interest rates are like a giant gas pedal that revs the engine of our economy, with the polished black dress shoe of Federal Reserve Chairman Jerome Powell pressed upon it.
For most of the past two decades, Jerome’s team and their predecessors have kept the pedal to the metal, firing a highly combustible stream of easy money into the system in the form of near-zero rates. This made mortgages more affordable, so everyone stretched to buy houses, which drove demand for new construction.
It also had a similar effect on business investment: borrowed money and venture capital was cheap, so lots of entrepreneurs borrowed lots of money and started new companies. These companies then rented offices and built factories and hired employees – who circled back to buy more houses, cars, fridges, iPhones, and all the other luxurious amenities of modern life.
This was a great party and it led to lots of good things, because we had two decades of prosperity, growth, raising our children, inventing new things and all the other good things that happen in a successful rich country economy.
Until it went too far and we ended up with too much money chasing too few goods – especially houses. That led to a trend of unacceptably fast Inflation, which we already covered in a recent article.
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So eventually, Jay-P noticed this and eased his foot back off of the Easy Money Gas Pedal. And of course when interest rates get jacked up, almost everything else in the economy slows down.
And that’s what is happening right now: mortgages are suddenly way more expensive, so people are putting off their plans to buy houses. Companies find that borrowing money is costly, so they are scaling back their plans to build new factories, and cutting back on their hiring. Facebook laid off 10,000 people and Amazon shed 27,000.
We even had a miniature banking crisis where some significant mid-sized banks folded and gave the financial world fears that a much bigger set of dominoes would fall.
All of these things sound kinda bad, and if you make the mistake of checking the news, you’ll see there is a big dumb battle raging as usual on every media outlet. Leftists, Right-wingers, and anarchists all have a different take on it:
It’s the President’s fault for printing all that money and running up the debt! We should have Fiscal Discipline!
No, it’s the opposite! The Fed is ruining the economy with all these rate rises, we need to drop them back down because our poor middle class is suffering!
What are you two sheeple talking about? The whole system is a bunch of corrupt cronies and we shouldn’t even have a central bank. All hail the true world currency of Bitcoin!!!
The one thing all sides seem to agree on is that we are “experiencing hard economic times” and that “the country is headed in the wrong way”.
Which, ironically, is completely wrong as well – our unemployment rate has dropped to 50-year lows and the economy is at the absolute best it has ever been, a surprise to even the most grounded economists.
The reality? We’re just putting the lid back onto the ice cream carton until the economy can digest all the sugar it just wolfed down. This is normal, it happens every decade or two and it’s no big deal.
Okay, but should I take my money out of the stock market because it’s going to crash?
This answer never changes, so you’ll see it every time we talk about stock investing: Holy Shit NO!!!
The stock market always goes up in the long run, although with plenty of unpredictable bumps along the way. Since you can’t predict those bumps until after they happen, there is no point in trying to dance in and out of it.
But since we do have the benefit of hindsight, there are a few things that have changed slightly: From its peak at the beginning of 2022 until right now (August 2023 as I write this), the overall US market is down about 10%. Or to view it another way, it is roughly flat since June 2021, so we’ve seen two years with no gains aside from total dividends of about 3%.
Since the future is always the same, unknowable thing, this means I am about 10% more excited about buying my monthly slice of index funds today than it was at the peak.
Should I start putting money into savings accounts instead because they are paying 4.5%?
This is a slightly trickier question, because in theory we should invest in a logical, unbiased way into the thing with the highest expected return over time.
When interest rates were under 1%, this was an easy decision: stocks will always return far more than 1% over time – consider the fact that the annual dividend payments alone are 1.5%!
But there has to be some interest rate at which you’d be willing to stop buying stocks and prefer to just stash it into the stable, rewarding environment of a money market fund or long-term bonds or something else similar. Right now, if a reputable bank offered me, say, 12% I would probably just start loading up.
But remember that the stock market is also currently running a 10% off sale. When the market eventually reawakens and starts setting new highs (which it will someday), any shares I buy right now will be worth 10% more. And then will continue going up from there. Which quickly becomes an even bigger number than 12%.
In other words, the cheaper the stocks get, the more excited we should be about buying them rather than chasing high interest rates.
As you can see, there is no easy answer here, but I have taken a middle ground:
I’m holding onto all the stocks I already own, of course
BUT since I currently have an outstanding margin loan balance for a house I helped to buy with several friends (yes this is #3 in the last few years!), I am paying over 6% on that balance. So I am directing all new income towards paying down that balance for now, just for peace of mind and because 6% is a reasonable guaranteed return.
Technically, I know I would probably make a bit more if I let the balance just stay outstanding, kept putting more money into index funds, and paid the interest forever, but this feels like a nice compromise to me
What if I want to Buy a House?
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For most of us, the biggest thing that interest rates affect is our decisions around buying and selling houses. Financing a home with a mortgage is suddenly way more expensive, any potential rental house investments are suddenly far less profitable, and keeping our old house with a locked-in 3% mortgage is suddenly far more tempting.
Consider these shocking changes just over the past two years as typical rates have gone from about 3% to 7.5%.
Assuming a buyer comes up with the average 10% down payment:
The monthly mortgage payment on a $400k house has gone from about $1500 at the beginning of 2022 last year to roughly $2500 today. Even scarier, the interest portion of that monthly bill has more than doubled, from $900 to $2250!
For a home buyer with a monthly mortgage budget of $2000, their old maximum house price was about $500,000. With today’s interest rates however, that figure has dropped to about $325,000
Similarly, as a landlord in 2022 you might have been willing to pay $500k for a duplex which brought in $4000 per month of gross rent. Today, you’d need to get that same property for $325,000 to have a similar net cash flow (or try to rent each unit for a $500 more per month) because the interest cost is so much higher.
And finally, if you’re already living in a $400k house with a 3% mortgage locked in, you are effectively being subsidized to the tune of $1000 per month by that good fortune. In other words, you now have a $12,000 per year disincentive to ever sell that house if you’ll need to borrow money to buy a new one. And you have a potential goldmine rental property, because your carrying costs remain low while rents keep going up.
This all sounds kind of bleak, but unfortunately it’s the way things are supposed to work – the tough medicine of higher interest rates is supposed to make the following things happen:
House buyers will end up placing lower bids which fit within their budgets.
Landlords will have to be more discerning about which properties to buy up as rentals, lowering their own bids as well.
Meanwhile, the current still-sky-high prices of housing should continue to entice more builders to create new homes and redevelop and upgrade old buildings and underused land, because high prices mean good profits. Then they’ll have to compete for a thinner supply of home buyers.
The net effect of all this is that prices should stop going up, and ideally fall back down in many areas.
When Will House Prices Go Back Down?
This is a tricky one because the real “value” of a house depends entirely on supply and demand. The right price is whatever you can sell it for. However, there are a few fundamentals which influence this price over the long run because they determine the supply of housing.
The actual cost of building a house (materials plus labor), which tends to just stay pretty flat – it might not even keep up with inflation.
The value of the underlying land, which should also follow inflation on average, although with hot and cold spots depending on which cities are popular at the time.
The amount of bullshit which residents and their city councils impose upon house builders, preventing them from producing the new housing that people want to buy.
The first item (construction cost) is pretty interesting because it is subject to the magic of technological progress. Just as TVs and computers get cheaper over time, house components get cheaper too as things like computerized manufacturing and global trade make us more efficient. I remember paying $600 for a fancy-at-the-time undermount sink and $400 for a faucet for my first kitchen remodel in the year 2001. Today, you can get a nicer sink on Amazon for about $250 and the faucet is a flat hundred. Similarly, nailguns and cordless tools and easy-to-install PEX plumbing make the process of building faster and easier than ever.
On the other hand, the last item (bullshit restrictions) has been very inflationary in recent times. I’ve noticed that every year another layer of red tape and complicated codes and onerous zoning and approval processes gets layered into the local book of rules, and as a result I just gave up on building new houses because it wasn’t worth the hassle. Other builders with more patience will continue to plow through the murk, but they will have less competition, fewer permits will be granted, and thus the shortage of housing will continue to grow, which raises prices on average.
Thankfully, every city is different and some have chosen to make it easier to build new houses rather than more difficult. Even better, places like Tempe Arizona are allowing good housing to be built around people rather than cars, which is even more affordable to construct.
But overall, since overall US house prices adjusted for inflation are just about at an all-time high, I think there’s a chance that they might ease back down another 25% (to 2020 levels). But who knows: my guess could prove totally wrong, or the “fall” could just come in the form of flat prices for a decade that don’t keep up with inflation, meaning that they just feel 25% cheaper relative to our higher future salaries.
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When Will Interest Rates Go Back Down?
The funny part about our current “high” interest rates is that they are not actually high at all. They’re right around average.So they might not go down at all for a long time.
Remember that graph at the beginning of this article? I deliberately cropped it to show only the years since 2009 – the long recent period of low interest rates. But if you zoom out to cover the last seventy years instead, you can see that we’re still in a very normal range.
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But a better answer is this one: Interest rates will go down whenever Jerome Powell or one of his successors determines that our economy is slowing down too much and needs another hit from the gas pedal. In other words, whenever we start to slip into a genuine recession.
In order to do that however, we need to see low inflation, growing unemployment, and other signs of an economy that’s not too hot. And right now, those things keep not showing up in the weekly economic data.
You can get one reasonable prediction of the future of interest rates by looking at something called the US Treasury Yield Curve. It typically looks like this:
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What the graph is telling you is that as a lender you get a bigger reward in exchange for locking up your money for a longer time period. And way back in 2018, the people who make these loans expected that interest rates would average about 3.0 percent over the next 30 years.
Today, we have a very strange opposite yield curve:
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If you want to lend money for a year or less, you’ll be rewarded with a juicy 5.4 percent interest rate. But for two years, the rate drops to 4.92%. And then ten-year bond pays only 4.05 percent.
This situation is weird, and it’s called an inverted yield curve. And what it means is that the buyers of bonds currently believe that interest rates will almost certainly drop in the future – starting a little over a year from now.
And if you recall our earlier discussion about why interest rates drop, this means that investors are forecasting an economic slowdown in the fairly near future. And their intuition in this department has been pretty good: an inverted yield curve like this has only happened 11 times in the past 75 years, and in ten of those cases it accurately predicted a recession.
So the short answer is: nobody really knows, but we’ll probably see interest rates start to drop within 18-24 months, and the event may be accompanied by some sort of recession as well.
The Ultimate Interest Rate Strategy Hack
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I like to read and write about all this stuff because I’m still a finance nerd at heart. But when it comes down to it, interest rates don’t really affect long-retired people like many of us MMM readers, because we are mostly done with borrowing. I like the simplicity of owning just one house and one car, mortgage-free.
With the current overheated housing market here in Colorado, I’m not tempted to even look at other properties, but someday that may change. And the great thing about having actual savings rather than just a high income that lets you qualify for a loan, is that you can be ready to pounce on a good deal on short notice.
Maybe the entire housing market will go on sale as we saw in the early 2010s, or perhaps just one perfect property in the mountains will come up at the right time. The point is that when you have enough cash to buy the thing you want, the interest rates that other people are charging don’t matter. It’s a nice position of strength instead of stress. And you can still decide to take out a mortgage if you do find the rates are worthwhile for your own goals.
So to tie a bow on this whole lesson: keep your lifestyle lean and happy and don’t lose too much sweat over today’s interest rates or house prices. They will probably both come down over time, but those things aren’t in your control. Much more important are your own choices about earning, saving, healthy living and where you choose to live.
With these big sails of your life properly in place and pulling you ahead, the smaller issues of interest rates and whatever else they write about in the financial news will gradually shrink down to become just ripples on the surface of the lake.
In the comments:what have you been thinking about interest rates recently? Have they changed your decisions, increased, or perhaps even decreased your stress levels around money and housing?
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* Photo credit: Mr. Money Mustache, and Rustoleum Ultra Cover semi gloss black spraypaint. I originally polled some local friends to see if anyone owned dress shoes and a suit so I could get this picture, with no luck. So I painted up my old semi-dressy shoes and found some clean-ish black socks and pants and vacuumed out my car a bit before taking this picture. I’m kinda proud of the results and it saved me from hiring Jerome Powell himself for the shoot.
As I’ve mentioned numerous times before, there were a number of problems that led up to the current mortgage crisis.
One was the explosion of subprime lending, which saw production spike during the end of the housing boom between 2005 and 2007, before ultimately coming to a standstill.
As illustrated by the graph above (data courtesy National Mortgage News), you can see that subprime lending volume was relatively modest in 1995 and 2000, but surged in 2005 and 2006, before easing in 2007 and completely dropping off this year.
Subprime originations, defined as A- to D loans, including some other “non-prime” mortgages, totaled just $35 billion, or 5.48 percent of the $639 billion in total residential mortgage production in 1995.
Five years later, subprime loan origination volume grew to $134 billion, but still only accounted for 12.56 percent of the $1.1 trillion in total residential production.
In 2005, subprime lending shot up to $795 billion, representing 24.13 percent of the $3.3 trillion in total residential home loan lending volume.
A year later, production fell to $674 billion, but still accounted for more than 20 percent of the $3.3 trillion in originations.
However, conditions changed quite abruptly in 2007, as subprime lending volume totaled just $182 billion and accounted for only 6.95 percent of residential production.
It’s forecasted that 2008 subprime originations will total just $10 billion, making up a mere 0.58 percent of the estimated $1.7 trillion in total residential lending volume.
Options traders buy calls when they believe prices will increase and purchase puts when they think prices will drop. But is there a way to profit if traders believe either that the price will remain stable, or the price will be unstable but the direction of movement is unclear?
Enter the butterfly spread strategy.
Butterfly spreads, depending on how they’re constructed, allow you to profit from either price stability or instability. In addition, they have the advantage of allowing traders to know their maximum gains and losses over the life of the trade.
Before engaging with a butterfly options trade, it’s best to learn how the myriad parts of a butterfly trading strategy works — and how to make that strategy work for you.
Butterfly Spread Defined
The butterfly spread — so named because of its “two wings on a butterfly” structure to the payoff graphs — is a go-to strategy for seasoned options investors looking for leverage while limiting downside risk.
Butterfly spreads are an advanced trading strategy, but if you’re a beginner there are other options strategies for you to explore.
Recommended: 10 Options Trading Strategies for Beginners
A butterfly options spread is an investment strategy that aims to profit from changes in volatility, take advantage of time decay, or both.
The object is to garner big trading returns on an asset whose price remains close to the strike price (when trading volatility is low) by the time the options contract expires. Butterfly options trades can be complicated in nature, but unlike many derivative trading strategies, butterfly trading strategies offer limited (i.e., known) gains and losses.
That “limit factor” derives from bull and bear spreads that in combination provide a price neutral strategy that keeps costs low, limits losses, and hopefully generates outsized returns.
Even so, butterfly options spreads do come with investment risk. Such trades should not be deployed by an investor unless the price of the underlying asset (such as a stock, bond, mutual fund, or exchange traded fund) remains fairly stable over the option contract’s entire time period.
💡 Quick Tip: If you’re an experienced investor and bullish about a stock, buying options online (rather than the stock itself) can allow you to take the same position, with less cash outlay. It is possible to lose money trading options, if the price moves against you.
How Does a Butterfly Spread Work?
Like any options trade, a butterfly spread trade is based upon the option’s underlying asset. The option contract itself spells out how the trade is structured.
Typically, when a trader looks at calls and puts in options they are concerned about the following key elements:
• Whether the trader is interested in call or put options.
• Will the trader be buying or selling/writing options.
• The strike price
• The options premium
• The expiration date (i.e., when the options contract ends).
With a butterfly spread, the contract owner typically forges a bullish and bearish price spread. The contract represents a neutral trading strategy with a quartet of options contracts that hold the same expiration date, but have three different strike prices (one option at a low strike price, two at-the-money options, and a fourth option at a higher strike price).
Recommended: What Are Stock Spreads?
The options at the higher and lower strike prices are equidistant from the at-the-money contract price — this represents the proper balance of the two wings attached to the butterfly’s body (i.e., the neutral options contract).
For example, if the asset is trading at $50, the higher and lower strike prices should be equally distant from the $50 strike price — at $40 and $60, for instance — each “wing” of the butterfly trading strategy would be $10 away from the current $50 asset price.
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Butterfly Spread Example
Here’s an example of a long call butterfly spread, one of the most common forms of butterfly spread trading.
An investor decides to invest in XYZ stock where prices are stable and five-year pricing fluctuations are minimal.
XYZ is currently trading at $55 and the investor expects shares to remain stable, but doesn’t want to take on too much risk.
Here’s the butterfly spread options trade that takes full advantage of the situation but limits any downside losses.
The investor:
• Buys an out-of-the money XYZ call expiring in two months with a strike price of $45
• Sells two at-the-money XYZ calls with strike prices of $55 and the same expiration as above
• Buys an out-of-the money XYZ call with a strike price of $65 also with the same expiration
Recommended: Guided to the Moneyness of Options
Note the equal balance between the three trades – each strike price is $10 from the $55 strike price on the two sold calls.
In total, the investor has purchased a pair of XYZ calls and has sold a pair of XYZ calls for the following amounts:
• Purchase of one out-of-the-money XYZ call at $45 for $700.
• Purchase one out-of-the-money XYZ call at $65 for $100.
• Sell two at-the-money XYZ calls at $55, gaining $600 on the sale.
At the end of the transaction, the investor spends a net total of $200 ($700 plus $100 minus $600 equals $200).
If XYZ prices remain stable and close at $55 on the expiration date, the investor will achieve the maximum profit on the trade of $800.
Maximum Profit = Price of $45 call – Price of $55 calls + Price of $65 calls – Initial investment
Calls that are out of the money expire worthless, therefore:
Maximum Profit = ($10 – $0 + $0) * 100 shares per option – $200 = $800
If the price of XYZ moves significantly (for example, it rises above $65 or falls below $45, the butterfly spread yields the maximum loss of the $200 spent to initiate the trade.
Maximum Loss = Net Premium Paid = $200
Finally the butterfly spread has two break even points:
Lower Break Even point = Strike of Lower Strike Long Call + Net Premium Paid Higher Break Even point = Strike of Higher Strike Long Call – Net Premium Paid Lower Break Even point = $45 + $2 = $47 Higher Break Even point = $65 – $2 = $63
Should XYZ settle between $47 and $63 per share at expiration, the trade will be profitable. How profitable is summarized in the graph below.
Note: The calculations and graph above disregard transaction costs, but due to the complexity of the butterfly spread these can add up. The smart trader considers these costs when initiating and exiting trades.
Types of Butterfly Spreads
Investors looking to engage with butterfly spread trading have several types of spreads to consider.
Long Call Butterfly Spread
This type of butterfly spread has a trader purchase three positions; an out-of-the-money call option at a low strike price, the sale of two at-the-money call options, and another purchase of an out-of-the-money call option with a higher strike price as in the example above.
An investor may earn the maximum profit if the underlying asset’s price remains stable and is the same as the written calls on the expiration date.
The maximum loss is represented by the trade entry cost, with trading fees added into the final amount.
Short Call Butterfly Spread
A short call butterfly spread is the inverse of a long call butterfly spread and is initiated when an investor sells a single out-of-the money call option with a low strike price, purchases two at-the-money call options, and sells an out-of-the money call option that has a higher strike price.
The maximum profit is the same as the initial premium collected minus the cost of trading fees but can be achieved two ways. If the stock moves substantially higher or if the price moves substantially lower. In this case, the trader expects the stock to move significantly but doesn’t know in which direction. One market scenario might be before an earnings call where the market’s expectations of results are unclear.
The maximum loss on the trade is equal to the difference between the lowest strike price and the center strike prices less the credit received on trade initiation. This will occur if the price remains stable.
Iron Butterfly Spread
An iron butterfly spread is a four-position transaction constructed when an investor buys an out-of-the-money put option that has a lower strike price, sells a single at-of-the money put option, sells a single at-of-the money call option, and buys an out-of-the money call option that has a higher strike price.
Maximum profit is achieved when the underlying asset is equal to the middle option strike price, along with the premiums provided via the iron butterfly spread trading strategy. The maximum loss is represented by the strike differential of the middle strike price minus the lower strike price less any premiums earned.
Pros and Cons of Using a Butterfly Spread
All options trades have advantages and disadvantages and butterfly spreads are no exception.
Pros of Butterfly Spreads
While profit is always the primary hoped for benefit of engaging in a trade, butterfly spreads do offer more.
Flexibility. Butterfly spread options allow the trader to construct trades to take advantage of varying scenarios.
Risk is limited. With a butterfly options trade, the maximum risk is limited and cannot exceed the parameters laid out upon initiation of the trade. Many options strategies can expose traders to unlimited losses.
Few surprises. With a butterfly options trade, a trader goes in knowing the maximum profit and loss linked to the trade.
Cons of Butterfly Spreads
Like any securities trade (especially with options trading), risks are a reality with butterfly spread trading. These potential downsides should be considered before engaging in any butterfly spread trades.
Complexity. There are scenarios where butterfly spreads are built with three or four different positions. This complexity comes with added transaction costs which can eat into potential profits. Butterfly spread options trading is complicated and not recommended for new investors.
Limited Reward. Butterfly options partner limited risk with limited reward. Hitting a home run with an option that allows an unlimited payoff is not in the cards here.
Assignment Risk. Options can be assigned at any time prior to expiration if an option is in the money. With so many moving parts the risk of assignment is real, with the other disadvantage that the butterfly spread collapses if any leg is assigned. This is manageable, but is a real risk.
Butterfly Spread Pros
Butterfly Spread Cons
Butterfly spreads are very flexible ways to profit from volatility or the lack thereof
Complexity comes with higher transaction costs
Limited Risk
Limited Reward
Few surprises
Assignment Risk
Use Your Options Trading Knowledge Today!
Investors looking to leverage butterfly spread options should know the trading strategy is complex and not without risk.
That said, a butterfly spread options strategy can yield significant profits if the expected scenario develops — and if the investor commits to the narrow options trading strategy that butterfly options trading demands.
Qualified investors who are ready to try their hand at options trading, despite the risks involved, might consider checking out SoFi’s options trading platform. The platform’s user-friendly design allows investors to trade through the mobile app or web platform, and get important metrics like breakeven percentage, maximum profit/loss, and more with the click of a button.
Plus, SoFi offers educational resources — including a step-by-step in-app guide — to help you learn more about options trading. Trading options involves high-risk strategies, and should be undertaken by experienced investors.
With SoFi, user-friendly options trading is finally here.
Photo credit: iStock/Kateryna Medetbayeva
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With 30-year mortgage rates now above 7%, a refinance likely isn’t in the cards for most homeowners.
In fact, the total number of refinance candidates has plummeted as interest rates have more than doubled.
Previously, around 18 million homeowners stood to benefit from a refinance. Today, it might be less than 100,000, per Black Knight.
Either way, it’s clear that refinancing has fallen out of fashion big time. The math just doesn’t make sense for most.
The question is what are your options other than refinancing, assuming you want a lower rate or cash out?
Why a Mortgage Refinance Doesn’t Make Sense Right Now
Yesterday, the Mortgage Bankers Association (MBA) reported that mortgage rates hit their highest levels since 2001, matching those seen briefly in October 2022.
They noted that refinance applications were off two percent from a week earlier and 35% from the same week a year ago.
If you look at the graph above, you can see why. The number of refinance candidates has fallen off a cliff.
Meanwhile, Freddie Mac said nearly two-thirds of all mortgages have an interest rate below 4%.
As such, refinancing the mortgage just doesn’t work for the majority of homeowners out there.
Simply put, trading in a fixed interest rate below 4% for a rate above 7% isn’t very logical, even if you really need cash.
In fact, during the first half of 2023, nearly nine out of 10 conventional loan refinance originations were cash out refinances.
Ultimately, if you’re looking for a lower rate via a refinance, you’re likely going to need to wait for rates to fall.
This explains why mortgage refinance volume has fallen to its lowest levels since the 1990s, as seen in the chart below.
Option 1: Open a HELOC
One popular refinance alternative is to take out a second mortgage, such as a home equity line of credit (HELOC).
The beauty of a second lien is that it doesn’t affect the terms of your first mortgage.
So if you’ve got a 30-year fixed locked in at 2-3% for the next 27 years or so, it won’t be disturbed.
You’ll continue to enjoy that low, low rate, even if you open a second mortgage behind it.
Another perk to a HELOC is that it’s a line of credit, meaning you have available credit like you would a credit card, without necessarily needing to borrow all of it.
This provides flexibility if you need/want cash, but doesn’t force you to borrow it all in one lump sum.
Closing costs are often low as well, depending on the provider, and the process tends to be a lot more streamlined than a traditional mortgage refinance.
Monthly payments are also typically interest-only during the draw period (when you pull out money) and only fully-amortized during the repayment period.
The major downside to a HELOC is that it’s tied to the prime rate, which has increased a whopping 5.25% since early 2022.
This means those who had a HELOC in March of 2022 saw their monthly payment rise tremendously, depending on the balance.
The potential good news is the Fed may be done hiking, which means the prime rate (which is tied to HELOCs) may also be done rising. And it could fall by next year.
So it’s possible, not definite, that HELOCs could get cheaper from 2024 onward.
Just pay attention to the margin, with combined with the prime rate is your HELOC interest rate.
Option 2: Open a Home Equity Loan
The other most common refinance alternative is the home equity loan, which like the HELOC is often a second mortgage (this assumes you already have a first mortgage).
It also allows you to tap into your home equity without resetting the clock on your first mortgage, or losing that low rate (if you’ve got one!).
The difference here is you get a lump sum amount when the loan funds, as opposed to a credit line.
Additionally, the interest rate on a home equity loan (HEL) is typically fixed, meaning you don’t have to worry about payments adjusting over time.
So it’s beneficial in terms of payment expectations, but those payments may be higher due to the lump sum you receive.
And you’ll likely find that HEL rates are higher than HELOC rates because you get a fixed interest rate.
Generally speaking, you pay a premium for a fixed rate versus an adjustable rate.
Also consider the origination costs, which may be higher if you’re pulling out a larger sum at closing.
It’s one thing if you know you need all the money, but if you just want a rainy day fund, a HELOC could be a better option depending on minimum draw amounts.
Be sure to compare the costs, rates, fees, and terms of both to determine which is best for your particular situation.
Lastly, note that some banks and lenders combine the features of these products, such as the ability to lock a variable interest rate, or make additional draws if you’ve paid back the original balance.
Put in the time to shop as rates and features can vary considerably compared to first mortgages, which are generally more straightforward aside from price.
Option 3: Pay Extra on Your First Mortgage
If you’ve been exploring a refinance to reduce your interest expense, e.g. a rate and term refinance, it likely won’t be a solution at the moment (as mentioned above).
Simply put, mortgage rates are markedly higher than they were just over a year ago.
Today, the 30-year fixed is averaging around 7%, more than double the 3% rates seen in early 2022.
This means most homeowners won’t be able to benefit from a refinance until rates fall significantly.
Of course, the more people who take out 7-8% mortgages today, the more opportunity there will be if and when they fall to say 5%, hopefully as soon as late 2024 if inflation gets under control.
In the meantime, there’s a solution and it doesn’t require taking out a loan, or even filling out an application.
All you have to do is pay extra each month, each year, or whenever you can. You can also set up a free biweekly mortgage payment system.
Whatever method you choose, each time you pay extra toward the principal balance of your mortgage, you reduce the interest expense.
So if you have a mortgage rate of 7% or higher, paying an extra $100 per month or more could lessen the blow.
You’d of course have to consider other options for your money, such as savings rates, investments, and other alternatives. And also your ability to devote more cash toward your home loan.
But this is a way to effectively reduce your mortgage rate without refinancing, which doesn’t pencil for most homeowners these days.
Just note that making extra mortgage payments does not lower future payments. So you’ll still owe the same amount each month unless you recast your loan.
But if and when rates do drop, you’d have a smaller outstanding balance thanks to those additional payments.
This could push you into a lower loan-to-value ratio (LTV) bucket, potentially making the refinance rate lower as well.
To sum things up, there are always refinance alternatives and strategies available, even if interest rates aren’t great.
And if history is any guide, there will come a time in the not-too-distant future when mortgage rates are favorable again.
Relative Strength Index, or RSI, is a momentum indicator used to measure a stock’s price relative to itself and its past performance. Developed by technical analyst J. Welles Wilder, the Relative Strength Index focuses purely on individual stock price movements to identify trading trends for a specific security, based on the speed and direction of those price changes.
RSI allows swing investors to compare the price of something to itself, without factoring in the performance of other stocks or the market as a whole. Investors use RSI to pinpoint positive or negative divergences in price for a security or to determine whether a stock is overbought or oversold.
The RSI indicator is useful in technical analysis, which revolves around finding trends in stock movements to determine optimal entry and exit points. Understanding what the Relative Strength Index measures and how it works is central to a technical trading strategy.
What Is RSI in Stocks?
The Relative Strength Index is a rate of change or momentum oscillator that tracks stock price movements. You can visualize it as a line graph that moves up or down, based on a stock’s price at any given time. The Relative Strength Index operates on a scale from 0-100. Where the RSI indicator is within this range can suggest whether a stock has reached an overbought level or if it’s oversold.
RSI is not the same thing as Relative Strength analysis. When using a Relative Strength Comparison (RSC), you’re comparing two securities or market indexes to one another to measure their relative performance. 💡 Quick Tip: Investment fees are assessed in different ways, including trading costs, account management fees, and possibly broker commissions. When you set up an investment account, be sure to get the exact breakdown of your “all-in costs” so you know what you’re paying.
How Does the RSI Indicator Work?
The Relative Strength Index operates on a range from 0-100. As stock prices fluctuate over time, the index can move up or down accordingly. Traders typically use the RSI to track price movements over 14 periods (i.e. trading days), though some may use shorter or longer windows of time.
When the RSI indicator reaches 70 or above, it could mean the underlying asset being measured is overbought. An RSI reading of 30 or below, on the other hand, suggests that the asset is oversold. The length of time a stock remains in overbought or oversold territory depends largely on the strength of the underlying trend that’s driving price movements.
The Relative Strength Index can throw off different patterns, depending on whether stocks are in a bull market or bear market. Investors compare the movements of the RSI indicator with actual price movements to determine whether a defined pricing trend actually exists and, if so, in which direction it might be heading. Analyzing moving averages for the stock can help determine the presence of a clear pricing trend.
Recommended: 5 Bullish Indicators for a Stock
RSI Formula
Here’s what the Relative Strength Index formula looks like:
RSI = 100 – (100 / (1 + RS))
In this formula, RS represents the ratio of the moving average of the tracking period’s gains divided by the absolute value of the moving average of the tracking period’s losses.
Here’s another way you might see the Relative Strength Index formula displayed:
RSI = 100 – [100 / ( 1 + (Average of Upward Price Change / Average of Downward Price Change ) ) ]
The RSI formula assumes that you’re able to follow a stock’s pricing changes over your desired tracking period. More importantly than that, however, is knowing how to make sense of Relative Strength Index calculations, which investors often display via a stock oscillator.
Interpreting RSI Results
Reading the Relative Strength Index isn’t that difficult when you understand how the different ranges work. Depending on where the RSI indicator is for a particular stock or market index, it can tell you whether the market is bullish or bearish. You can also use the RSI, along with other technical analysis indicators, to determine the best time to buy or sell.
Above 70
An RSI reading of 70 or higher could indicate that a stock is overbought and that its price might move back down. This could happen through a reversal of the current price movement trend or as part of a broader correction. It’s not unusual for stocks to have an RSI in this range during bull market environments when prices are rising. If you believe that the stock’s price has reached or is approaching an unsustainable level, an RSI of 70 or higher could suggest it’s time to exit.
Below 30
When a stock’s RSI reading is 30 or below, it typically means that it’s oversold or undervalued by the broader market. This could signal a buying opportunity for value investors but it could also indicate the market is turning bearish. It’s more common to see RSI readings of 30 or below during downtrends when stock prices may be in decline across the board.
40 to 90 Range
During bull markets, it’s not uncommon to see the Relative Strength Index for a stock linger somewhere in the 40 to 90 range. It’s less common to see the RSI dip to 30 or below when prices are steadily moving up. An RSI reading of 40 to 50, roughly the middle of the 0-100 scale can indicate support for an upward trend.
10 to 60 Range
In bear markets, or those filled with fear, uncertainty, and doubt, it’s more common to see the Relative Strength Index hover somewhere in the 10 to 60 range. It’s not unusual for stocks to reach 30 or below when the market is already in a downward trend. The middle point of the RSI can act as a support point, though the range shifts slightly to between 50 and 60.
Common RSI Indicators
Relative Strength Index indicators can help investors spot pricing trends. That includes identifying up and down trends, as well as sideways trends when pricing levels consolidate. The reliability of these indicators often hinges on the current phase of a stock or the market as a whole. When reading RSI indicators, it’s important to understand divergence and swing rejections.
Divergence
A divergence represents a variation or disagreement between the movement of the RSI indicator and the price movements on a stock chart. For example, a bullish divergence means the indicator is making higher lows while the price movement is establishing lower lows. This type of divergence can hint at increasing bullish momentum with a particular stock or the greater market.
A bearish divergence, on the other hand, happens when the indicator is making lower highs while prices are establishing higher highs. This could indicate that investor sentiment is becoming less bullish.
Swing Rejections
A swing rejection is a specific trading technique that involves analyzing RSI movements when pushing above 30 or below 70. Swing rejections can be bullish in nature or bearish.
For example, a bullish swing rejection has four parts or steps:
• RSI is at an oversold level
• RSI moves above 30
• A dip is recorded without rating as oversold
• RSI passes its recent high
Meanwhile, a bearish swing rejection also has four parts or steps:
• RSI reaches an overbought level
• RSI drops below 70
• RSI hits new highs without dropping back to overbought levels
• RSI passes recent lows
Swing rejections make it possible to utilize divergence indicators to spot bullish or bearish trends in their earliest stages. 💡 Quick Tip: How to manage potential risk factors in a self-directed investment account? Doing your research and employing strategies like dollar-cost averaging and diversification may help mitigate financial risk when trading stocks.
Is RSI a Good Indicator to Use?
Yes, in certain circumstances. Relative Strength Index can be a good indicator to use in technical analysis, as it can make it easier to detect when a stock or the broader market is overbought or oversold. Understanding how to interpret RSI and its correlation to price movements could help you spot buy or sell signals and detect bull market or bear market trends.
That said, RSI also has some limitations. For example, the RSI can produce false positives or false negatives when bullish or bearish trends don’t align with the way a stock’s price is moving. Like other technical analysis indicators, it’s not an exact way to gauge the market’s momentum. So if stocks are hovering somewhere in the 40 to 60 range, it may be difficult to decipher whether the mood is bearish or bullish.
When using RSI, it’s helpful to incorporate other technical analysis indicators to create a comprehensive picture of the market. Exponential moving average (EMA), for example, is a type of moving average that uses the weighted average of recent pricing data to draw conclusions about the market.
Traders often use RSI in conjunction with other trend indicators, such as the Moving Average Convergence Divergence, the Stochastic Oscillator, or the Volume-Weighted Average Price.
RSI vs MACD
Moving Average Convergence Divergence (MACD) is a technical analysis indicator that investors may use alongside RSI. This indicator can help them determine when to buy or sell, based on the correlation between two moving averages for the same security.
Specifically, it requires looking at a 12-period moving average and a 26-period moving average. To find the MACD line, you’d subtract the 26-period from the 12-period, resulting in a main line. The next step is creating a trigger line, which is the nine-period exponential moving average of the main line. The interactions between these two lines can generate trading signals.
For example, when prices are strongly trending in a similar direction the main line and trigger line tend to move further apart. When prices are consolidating, the lines move closer together. If the main line crosses the trigger line from below, that can produce a buy signal. If the main line crosses the trigger line from above, that can be construed as a signal to sell.
While RSI and MACD are both trend indicators, there are some differences. Relative Strength Index measures the distance between pricing highs and lows. So you’re looking at the average gain or loss for a security over time, which again usually means 14 periods. The MACD, on the other hand, focuses on the relationship between moving averages for a security. It’s a trend-following signal that, like RSI, can indicate momentum.
RSI vs Stochastic Oscillator
The stochastic oscillator is a momentum indicator for technical analysis that shows where a stock’s closing price is relative to its high/low pricing range over a set period of time. The stochastic oscillator can also be used to track pricing for a market index.
Central to the use of the stochastic oscillator is the idea that as a stock’s price increases, the closing price inches closer to the highest point over time. When the stock’s price decreases, the closing price lands closer to the lowest low. Investors use this indicator to determine entry and exit points when making trades.
However, investors interpret RSI and stochastic oscillator readings differently. For example, with a stochastic oscillator, a reading of 20 or below generally means a stock is oversold, versus the 30 or below range for RSI readings. When used together, Relative Strength Index and stochastic oscillators can help with timing trades to maximize profit potential while minimizing the risk of losses.
Can You Use RSI to Time the Crypto Market?
Stocks are not the only asset class for which investors use the RSI. Investors also use the Relative Strength Index to assess conditions in the crypto markets and whether it’s time to sell or continue to HODL.
Cryptocurrency traders may use RSI to gauge momentum for individual currencies. Again, they’re looking at the highs and lows to get a sense of which way prices are moving at any given time. The RSI indicator can help with choosing when to buy or sell, based on previous price movements.
The same rules apply to crypto that apply to stocks: An RSI reading of 70 or above means overbought while a reading of 30 or below means oversold. Likewise, a reading above 50 signals a bullish trend while a reading below 50 can signal a bearish trend. Investors can also use a bearish divergence or bullish divergence to spot a pullback or an upward push.
As with stocks, however, it’s important to remember that RSI is not 100% accurate.
Recommended: Crypto Technical Analysis: What It Is & How to Do One
The Takeaway
RSI can be used to pinpoint positive or negative divergences in price for a stock or to determine whether it’s overbought or oversold. If you’re interested in technical analysis and trending trading, RSI can be a useful metric for making investment decisions.
The RSI is just one tool that you can use to devise a strategy for your portfolio. There are other less technical tools you can use as well when you’re starting to build a portfolio.
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The numbers to know about the world’s biggest cryptocurrency.
This article originally appeared on Finder.com and has been republished here with permission.
The first digital currency and the largest, Bitcoin makes up 39% of the total value of the biggest 250 cryptocurrency coins as of September 2022.
Bitcoin’s founding is the stuff of legend: It was created in 2009 under the alias Satoshi Nakamoto – an unknown entity who believes future currencies shouldn’t be controlled by a central government or agency.
The first Bitcoin hit the market in July 2010 at a cost of under $0.01. It took three years for the currency to reach more than $1,000. Since 2013, Bitcoin has smashed all records. It peaked at $69,045 back in November 2021. The current price of Bitcoin is around $22,259 — or 8.8% lower than what it was just one month ago. All prices are quoted in US dollars.
The price of Bitcoin has changed by -$1,963 over the past day, with yesterday’s price of about $31,818 and today’s price of $29,855. The number of Bitcoin currently in circulation is 19,055,843. While there can only be 21 million Bitcoin created, it’s estimated that this maximum won’t be reached within the next 100 years.
Bitcoin is by far the biggest cryptocurrency in terms of market capitalization — or total value in existence. Currently, $424 billion worth of Bitcoin is out in the wild. Bitcoin surpassed a market cap of $1 trillion for the first time in February 2021. Ethereum, the second most popular currency, has a market cap of $210 billion.
Some $36 billion worth of Bitcoin has been traded over the past 24 hours. The graph below depicts the volume of Bitcoin traded daily. This figure can be somewhat volatile, with $12 billion traded on one of its worst days and $72 billion traded on one of its best.
The price of Bitcoin can also be volatile. Elon Musk announced in February 2021 that Tesla had purchased $1.5 billion worth of Bitcoin and would be accepting the currency as payment, paving the way for larger companies to adopt Bitcoin and sending the price soaring. Musk reversed that announcement in May and declared that Tesla would no longer accept Bitcoin due to its high carbon footprint, leading to an immediate crash of the Bitcoin price to roughly where it was before his first tweet.
While you’ll find excellent guides covering how to invest in Bitcoin, as with any cryptocurrency, it’s wise to invest with caution.
It’s not uncommon for homeowners to take out a home equity line of credit (HELOC) behind their first mortgage to pay for home renovations or to pay off other high interest rate debt.
Or simply to take one out as a second mortgage to get the financing they need to purchase a home.
But the way HELOCs are currently structured, homeowners have a tendency to get into a lot of trouble, especially if monthly payments rise significantly after the initial 10-year draw period.
These days, most HELOCs allow for a 10-year interest-only period, followed by a 10- or 15-year repayment period.
In other words, homeowners can make interest-only payments for a decade before actually paying back any of the money they borrow.
Once the draw period ends, they must begin paying back all the debt over a shorter term (not 30 years), which will result in much higher payments.
For example, a $25,000 line of credit set at 3.25% (current prime rate) would cost about $68 per month when making the interest-only payment.
Payment Shock = Payment Default
That payment jumps up to over $175 a month once you’re required to make the full principal and interest payment and pay it off in just 15 years. And that’s assuming the prime rate remains at a super low 3.25%.
If interest rates rise during the draw period, which they probably will, the payment shock will be even greater. Many of these products don’t have any periodic interest rate caps in place, just a max interest rate of say 18%.
Long story short, the greater the payment shock, the greater the default rate. It’s actually perfectly correlated, as you can see from the graph above from Equifax/WSJ.
Clearly this is a problem, especially if homeowners take out of these HELOCs when home prices are inflated, which many did during the past boom years.
In 2004, HELOCs outstanding increased 42%, so many of these products have now switched over to the fully amortized payment. These so-called resets pose a threat to the ongoing housing recovery, and many more are expected in 2015, 2016, and so on.
And with home prices still not back to peak levels, many of these homeowners are still in underwater positions, meaning their motivation to make a higher payment each month might be quite low. Hello default.
Wells Fargo Is Ending Interest-Only on HELOCs
Most HELOCs have an interest-only option
For the first 10 years
Removing it will make the loans safer
Assuming the borrowers hold a balance long-term
To combat the possible repercussions of these nasty resets, Wells Fargo is getting rid of the interest-only option on its HELOCs.
Wells Fargo Home Mortgage Executive Vice President Brad Blackwell told the WSJ that “it’s the right thing to do for our customers,” and that they want to the lead the industry toward a “more responsible” product.
Additionally, he said they wanted to “fix a flaw in the product” that allowed monthly payments to rise significantly. Clearly this is also bad for Wells Fargo, which happens to hold billions in home equity debt.
So the move should help the bank as well. It also aligns with the new Qualified Mortgage rule, which banned interest-only first mortgages.
Lenders are still allowed to offer an IO option on home equity lines, and they probably will continue to do so because of the harsher rules on first mortgages. Consider it a loophole.
For the record, Wells will continue offering an interest-only option on HELOCs to wealthy customers who can handle any and all payment increases without batting an eye.
In the meantime, they still have to contend with $28 billion in HELOC resets from now through 2017. The bank noted that it reaches out to borrowers facing a reset to lessen the blow of a payment increase.
The San Francisco-based bank accounted for about 14% of all home-equity lending in 2013, making it the nation’s largest first and second mortgage lender.
A lot of people including Jerome Powell who runs the Federal Reserve assume high interest rates will make housing cheaper. They believe that higher rates make houses less affordable and therefore, prices will decrease. There are many things wrong with this line of thinking, but they are missing an incredibly important concept. High rates may cause a temporary drop or leveling off in prices, but over the long term, they are certain to cause higher prices. This is because higher interest rates make it more expensive to build houses. As a result, fewer people and developers will be able to afford to build, which will lead to a decrease in inventory. We already have a massive shortage of houses in the United States which has caused big increases in prices. Reducing building will make that shortage even worse and make prices higher in the future.
Have high rates lowered real estate prices in the past?
Many people including Powell assume high rates make prices drop or level off. This is one of Powell’s quotes from 2022:
“Housing is significantly affected by these higher rates, which are really back where they were before the global financial crisis,” Powell said during a news conference. “The housing market was very overheated for a couple of years after the pandemic, as demand increased and rates were low. The market needs to get back into a balance between supply and demand.”
When he said this, rates were lower than they are now and mortgage rates are much higher than they were prior to the global financial crisis. People were also used to higher rates from the 80s and 90s back then whereas people are used to very low rates now.
However, historically raising interest rates has never lowered housing prices. There are even multiple studies that show high interest rates have never caused prices to drop. The 70s and 80s had some of the highest interest rates in our history and the 70s also had the highest appreciating real estate market in the last 100 years.
High rates make it more expensive to buy homes but they also reduce the inventory because people do not want to sell and lose the lower rate they currently have. High interest rates often reduce sales but not prices. High rates also make many things more expensive.
Here is a video I did two years ago talking about what raising rates would do to the real estate market:
How do high interest rates make building a house more expensive?
Building houses is not easy in today’s government-regulated environment. Building codes and development requirements get stricter by the minute. The harder you make it to build or develop, the higher new construction costs are but that is another topic. Here is why higher rates cause new construction to be more expensive:
Material costs: Almost every company uses debt or sources supplies from companies that use debt. If the cost of debt increases, that means the cost of supplies increase, and prices therefore increase as well. We have seen many supply chain issues with construction materials as well. It is really hard to fix those issues and expand production when the cost of borrowing money is so high.
Labor costs: Labor costs can also increase when interest rates are high. This is because workers will demand higher wages to compensate for the higher cost of living. We hear all the time how inflation has made it tough on the poor and middle class. However, raising wages to battle inflation causes more inflation. Powell has said numerous times wage increases are one of the big causes of inflation.
Debt costs: Most people use debt to build houses and home builders use debt as well. If the cost of debt increases, that increases the cost of building.
How do high interest rates decrease new construction?
Not only do high interest rates increase the cost of new construction, but they also decrease the number of new builds. I mentioned before how prices usually do not decrease with high rates but sales often do. While prices may not decrease, or only decrease for a short amount of time, sales almost always decrease with higher rates. It is harder to sell houses because of the higher rates which makes builders wary to build more. It can take more than a year to build a house and if the builders have a concern about real estate demand, they will hold off and not risk building or building as much.
With higher rates, we also see higher construction costs as discussed earlier. If the price to build goes up, that will also make builders hesitant to start new builds. How can they be sure the market with higher rates will support the higher prices? Historically, the market has supported higher prices even with higher rates but that is still a big risk to take!
The graph below shows single-family new construction starts. We saw record low building for years after the housing crash and we were starting to get back to normal when interest rates spiked. You can see the huge drops in new builds in 2022 and while it has increased some, it is nowhere close to where it needs to be to catch up to demand.
How does less new construction raise prices?
The USA has a housing shortage as do most areas of the world. The governments keep making it harder to build and develop and then wonder why there is less building! If there is a shortage of housing, that means more people are fighting over fewer houses, and that increases prices. The less building there is, the higher prices will go as the population will keep increasing and moving around the country looking for new housing that is not available.
Powell may have thought higher rates would make housing more affordable, but I am not sure if he considered the long-term impact higher rates have. They will most certainly decrease new construction and raise the cost of construction which in the long-term will increase prices. The longer rates are high, the worse the problem will get. Ever heard the term kicking the can down the road? They may not want to lower rates now because a buying frenzy could ensue, but the longer they wait the worse they are making the problem.
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Overall, higher interest rates are likely to have a negative impact on the construction industry. This is because they will make it more expensive to borrow money, finance projects, and hire workers. As a result, we can and have seen a decrease in new construction which will make the inventory problem worse, which will most likely make housing even more expensive in the future.
As we enter the second quarter of 2021, it’s time for the mortgage industry to reflect on the past 12 months and think about how to plan for the same period ahead. After all, it was mid-March of last year that the president declared a national emergency leading to school closures, the wearing of masks, and the emptying of office buildings across the country. A little over a year ago, we could have never imagined the actual implications of COVID’s impact to come on this nation, our communities, families and our business.
Take working remotely for example. In early 2020, Zoom was barely a known company in America. The impact of COVID made it a household name. By October, the market value of Zoom exceeded that of Exxon-Mobile, reflecting the dichotomy of an intransigent society staying at home and working remote. The stock value of Zoom grew 650% during this one year as many other aspects of the economy slowed or shuttered as a result of the shutdown.
But housing was the true bright spot in the economy. Low mortgage rates, driven by quantitative easing by the Federal Reserve helped fuel a boom in both mortgage refinancing and purchases, making 2020 the second-best year in U.S. history for mortgage origination volume. Augmenting the low rates was an increase in demand driven by the sudden surge of the millennials, finally now out to buy a home.
In fact, as reported in the Wall Street Journal in late August of 2020, “Millennials reached a housing milestone in 2020 when the group first accounted for more than half of all new home loans, and they consistently held above that level in the first months of 2021, the most recent period for which data are available, according to Realtor.com. The generation made up 38% of home buyers in the year that ended July 2019, up from 32% in 2015, according to the National Association of Realtors.”
Now, with the economy looking toward life past COVID, the focus is beginning to shift to a recovering economy, perhaps hotter than expected, driven by an excess in stimulus provided, and a likely end to the low single-digit mortgage rates seen over the previous year.
But a reminder to all is relevant now. Low rates are often the sign of a poor economy. As Bankrate’s Chief Economist Greg McBride, recently highlighted: “Bad economic news is often good news for mortgage rates. When concern about the economy is high, investors gravitate toward safe-haven investments like Treasury bonds and mortgage bonds, pushing bond prices higher but the yields on those bonds lower.”
So, the good news is that the economy will survive COVID and may actually catch on fire in the rebound with GDP forecasted to grow by 6.5% this year. Job growth will be the result of increased spending across every sector — from travel to goods and services. In fact, the pent-up demand can be reflected by the growth in retained savings after expenses during COVID, as Economist Mark Zandi of Moody’s Analytics highlights.
With 916,000 jobs created in March, many economists are bracing for what might be a spending spree from a nation that has been locked away for far too long and now recovering at a record pace. With summer on the horizon, look for the pace of spending to only grow with tourism augmenting what would already be a robust growth spree.
In fact, the recovery from the COVID pandemic is in stark contrast to that of the 2008 Great Recession. The fact that this recession was brought on by a virus versus weakening economic variables is key to the distinction. If you compare the employment growth between the two recessions there is truly no comparison.
Low interest rates, the demand surge from the millennials that are now reaching peak buying years, significant stimulus brought on by three large recovery bills, not to mention a potential infrastructure package, and massive pent-up demand from the lack of spending over the past year should have everyone simply bracing for lift off from the U.S. economic engine as it fires up.
So mortgage rates will likely continue to rise modestly as the Fed tapers from its intervention in the MBS (mortgage backed security) supply, which will slow refinancing and thus reduce mortgage volume overall in the market. Clearly, mortgage forecasts from the MBA and others reflect the expectation that overall volume will slow, but purchase activity will continue to grow.
For those that have focused on purchase lending, they will see less of a drop in total volume. But for those that have overly depended on refinancing, the impact will be more severe. Fortunately for lenders that were already more purchase-focused, the impact will be far less than many other refinance dependent operations given the strong purchase to refinance mix.
And one last perspective is important for everyone. The graph below from the Federal Reserve of St. Louis is the most important point about perspective. Look at 30-year mortgage rates as they stand today compared with any time going back decades when these rates were even captured on an aggregate basis. Rising mortgage rates will certainly be tolerated by the market.
In fact, small hikes in mortgage rates can lead to panic-buying periods which can drive small volume surges. Mortgage rates have never been this low and yet through previous cycles home sales have continued. In fact, the largest home purchase year in this nation’s history was 2005 when rates were near 7.5%.
The nation’s greatest obstacles ahead will come from the shortages in available single family home inventory across the county. But as America returns to work, supplies for builders will return to needed production levels, new home construction will continue to rise, and ultimately the supply-demand imbalance will rectify itself. The current proposed infrastructure bill includes funding for over 100,000 affordable housing units among many other housing initiatives, reflecting the recognition of the need to address access and supply to affordable homes.
For those in the mortgage banking industry, market corrections are part of the business. But in the year ahead, while having less mortgage volume overall, it will be met with a strengthening economy, a healthier nation, and enormous demand for home ownership. How lenders re-tool for this shift to a stronger economy and a purchase-dominated mortgage market will be the most important variables in long-term success. For companies that prepare for this, the market shift will be far less impactful compared to so many others.
This column does not necessarily reflect the opinion of HousingWire’s editorial department and its owners.
To contact the author of this story: Dave Stevens at [email protected]
To contact the editor responsible for this story: Sarah Wheeler at [email protected]