Tax cuts are great, right? Not necessarily, if you’re planning to get a mortgage in the next few years.
Mortgage rates have increased dramatically in 2018, and tax cuts get at least some of the blame for that. Expanding federal budget deficits brought about by the tax cuts could shove mortgage rates even higher, perhaps past 6% in the next couple of years.
Higher rates could make it harder to afford a home. But that’s not a reason to buy hastily and risk ending up with the wrong home in the wrong location. Before 2008, mortgage rates north of 6% were pretty common, and there’s always the option of getting an adjustable-rate mortgage with a low introductory rate.
How tax cuts lead to higher rates
Tax cuts result in higher interest rates in two ways, economists say:
- They stimulate the economy, which leads to inflation
- They swell the budget deficit, forcing businesses and consumers (including home buyers) to compete with the federal government to borrow money
Let’s unpack these effects.
A hotter economy brings inflation
Congress passed tax cuts near the end of December, and they went into effect in January. Mortgage rates began climbing in the second week of the year. The 30-year fixed averaged 4.59% in March — half a percentage point higher than in December.
» MORE: See NerdWallet’s daily mortgage rate survey
Why did rates go up? “Passing of the tax cut bill, which heats up the economy,” says Mark Fleming, chief economist for First American Financial Corp.
The tax cuts give consumers more money to spend: Disposable income is projected to grow 4.4% in 2018 and 2019, according to the Congressional Budget Office. That stimulus, on top of an economy with a low unemployment rate, could cause prices to rise eventually. And long-term interest rates, such as those for mortgages, “are usually a reflection of expectations for inflation,” Fleming says.
Deficits make borrowers compete
Mortgage rates are expected to get a further upward push in the next four years as federal budget deficits grow, according to the latest CBO projections. The deficits are expected to increase from 4.2% of gross domestic product this year to 5.1% of GDP in fiscal 2022.
“Throughout the projection period, rising federal debt relative to GDP exerts upward pressure on short- and long-term interest rates,” including mortgage rates, the CBO says in its April budget and economic outlook.
As the U.S. government, foreign governments, businesses and consumers all try to borrow at the same time, they bid up the price of money — and that means higher rates on everything from government bonds to mortgages.
“When people crowd into the market, you have to pay more because there’s competition out there,” says Robert Frick, corporate economist for Navy Federal Credit Union.
» MORE: 3 housing trends for spring 2018
The CBO predicts that yields on 10-year U.S. Treasurys will rise to 4.1% in 2020 and 4.2% in 2021, up from 2.3% in 2017. That matters because rates on 30-year, fixed-rate mortgages tend to follow 10-year Treasury yields. If the 10-year Treasury rises, mortgage rates will go up, too, by roughly the same amount.
The last time the 10-year Treasury hung around 4.1% was December 2007. That month, the 30-year, fixed-rate mortgage averaged 6.1%. That’s a jump from March 2018, when the 10-year Treasury averaged 2.84% while the 30-year mortgage averaged 4.59%.
But incomes may rise, too
Economists emphasize that the tax cuts bring more than higher deficits and interest rates. They’re expected to result in higher incomes, too, in two ways:
- Even if your income stays the same, your take-home pay increases as less tax is withheld
- More jobs are created as people, businesses and government spend more, and employers raise wages to compete for workers and hang on to the employees they have
“The interest rate is not the only thing that’s moving. Income is growing faster. So that’s potentially an offset,” says Tian Liu, chief economist for Genworth Mortgage Insurance.
Fleming, of First American Financial, says higher incomes mean more buying power, which is good for the housing market. Others in the housing industry echo this optimistic view.
On the other hand, Liu points out that a mortgage rate increase of even half a percentage point can gobble up a modest increase in take-home pay. “I think affordability will get more eroded in 2018,” Liu says. “I think that’s really a headwind for housing.”
Some are skeptical that wages will rise quickly. Dean Baker, senior economist for the Center for Economic and Policy Research, believes the economy might have the capacity to create many more jobs before wages start going up.
“If we actually start to get close to full employment and it’s starting to put pressure on the economy, we’d see higher inflation, leading to higher interest rates,” he says. “I don’t know if we’re at that point yet.”
How to deal
You can’t fight higher interest rates and inflation, but you can learn to live with them:
Don’t rush. Buy a home when you’re ready to own and not before. If your life and career are still in flux, keep renting until you know it’s time to settle down. If you need to wait to save up for a down payment, keep doing that. In a recent survey conducted on behalf of NerdWallet, 11% of millennial homeowners said they should have waited until they could make a bigger down payment.
Keep things in perspective. Today’s 30-year mortgage rates are under 5%. From 1972 (when Freddie Mac’s records begin) through 1979, the 30-year fixed averaged 9.03%. It averaged 12.71% in the 1980s, 8.12% in the 1990s and 6.29% from 2000 through 2009. And in those decades of higher mortgage rates, people still bought houses.
Learn about ARMs. As fixed mortgage rates rise, more borrowers will get adjustable-rate mortgages, says Mat Ishbia, president and CEO of United Wholesale Mortgage. The introductory rates on ARMs tend to be lower than fixed-rate mortgages. ARM rates can rise later, though. Ishbia says educating consumers about ARMs will become an important part of his company’s business in the next few years.