by Lance Roberts, Clarity Financial

This past week, the lovely, and talented, Danielle DiMartino-Booth and I shared a discussion on the ongoing debate of why “Rates Must Rise.”  


For the last several years, I have produced a litany of commentary (see this, this and thison why rates WILL not rise anytime soon, they CAN’T rise because of the relationship between debt and economic activity.

Most of the arguments behind the “rates must rise” scenario are based solely on the premise that since “rates are so low,” they must now go up. This theory certainly applies to the stock market which is driven as much by human emotion, as fundamentals. However, rates are an entirely different animal.

Let me explain my position using housing as an example. Housing is something everyone can understand and relate to, but the same premise applies to everything bought on credit.

People Buy Payments – Not Houses

When the average American family sits down to discuss buying a home they do not discuss buying a $125,000 house. What they do discuss is what type of house they “need” such as a three bedroom house with two baths, a two car garage, and a yard.

That is the dream part.

The reality of it smacks them in the face, however, when they start reconciling their monthly budget.

Here is a statement I have not heard discussed by the media. People do not buy houses – they buy a payment. The payment is ultimately what drives how much house they buy. Why is this important?   Because it is all about interest rates.

Over the last 30-years, a big driver of home prices has been the unabated decline of interest rates. When declining interest rates were combined with lax lending standards – home prices soared off the chart.  No money down, ultra low interest rates and easy qualification gave individuals the ability to buy much more home for their money.

The problem, however, is shown below. There is a LIMIT to how much the monthly payment can consume of a families disposable personal income.

In 1968 the average American family maintained a mortgage payment, as a percent of real disposable personal income (DPI), of about 7%. Back then, in order to buy a home, you were required to have skin in the game with a 20% down payment. Today, assuming that an individual puts down 20% for a house, their mortgage payment would consume more than 23% of real DPI. In reality, since many of the mortgages done over the last decade required little or no money down, that number is actually substantially higher. You get the point. With real disposable incomes stagnant, a rise in interest rates and inflation makes that 23% of the budget much harder to sustain.

To illustrate this point, look at the chart below. Let’s assume we buy a $125,000 home. I have projected the monthly payment of that home assuming a rise in interest rates going forward back to the long-term median of roughly 8%. Pick a rate in the future and you can see what the payment would be.

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