Interest rate spike endangers economy

Those days when neighbors could lean across the hedge and brag about their new ultra-low mortgage rates are just about over.

Within the past few weeks, long-term interest rates have spiked by almost a full percentage point, probably ending one of the nation's greatest mortgage-refinancing booms in history. The higher rates - almost back to where they were a year ago - mean that many people will no longer be able to afford to borrow as much money. This may eventually affect housing prices, which have been just about the best performing investments in the American portfolio.

If the housing market fades, analysts expect it could ripple widely through the fragile US economy. Americans have been using refinancing to pay for their kids' college tuition, lower the debt on their credit cards, and take the family to Disneyland. In essence, savings on the mortgage had become one way millions of Americans could afford their lifestyle.

"With [the refinancing boom] ending, for the economy as a whole this is bad news," says Lyle Gramley, a former governor of the Federal Reserve Board.

It may be bad news - especially for consumer spending - but it is not unexpected. Economists had been expecting long-term interest rates to start trending upward once the economy came to life. "We just didn't expect it to come this far and this fast," says Doug Duncan, chief economist for the Mortgage Bankers Association in Washington.

Behind the quick rise in rates is the bond market's anticipation that the economy is on the road to higher growth. The market has also reacted to the news that the US budget deficit would be higher than expected. Then, Mr. Duncan says, the bond market became confused by conflicting signals from the Federal Reserve, which sometimes has hinted at a need for more cuts, and other times has said the economic recovery has begun.

The changes have been so swift that many mortgage shoppers have been caught by surprise. "People who are looking for houses are counting on the 5-1/2, which has been the rule for the last couple of months," says Sofia Stafford, a real estate agent with Re/Max Northwest in Des Plaines, Ill., a suburb north of Chicago. "Now they are finding a house, and the rates are already at 6-1/2 or so."

One of those caught by surprise is Scott Gladstone, a father of three who refinanced his Brookline, Mass., home twice in 2002 and again in 2003. He was preparing to get an even lower rate a few weeks ago when, he says, "the rates just shot straight up."

Now, Mr. Gladstone is hoping that the economic rebound does not occur since he is "poised" to take advantage of another drop in rates. "That's not very patriotic to hope for that. So I'm a little bit torn," says Gladstone, a lawyer who just opened his own business in Newton.

Mortgage refinancing is a relatively recent phenomenon. Twenty years ago, most Americans would take a 30-year fixed-rate mortgage and just start making payments. But, as interest rates became volatile, mortgages rates started to rise and fall more sharply. Americans started watching the financial pages more closely.

Typical is Kathy Stout of Lompoc, Calif., who refinanced her home in December, only to see rates drop another whole percentage point by summer.

So she listened to her financial adviser and refinanced again in June. She and her husband are now paying 4.625 percent, down from 5.536 percent. She figures the lower rate on the 15-year loan will save them about $20,000 over the life of the loan.

"Now they are going back up, so we were really lucky," she says.

The higher rate means that some buyers won't be able to afford the same level of mortgage. For example, someone borrowing $200,000 at the low point for rates, 5.2 percent, would have a $1,100 monthly payment. Now, to have the same monthly payment, that person could afford only a $180,000 loan.

"Maybe instead of a four-bedroom, they will have to settle for a three-bedroom," says Lawrence Yu, an economist for the National Association of Realtors.

For the past several years, housing prices have been rising at about 8 percent per year. However, in some markets, they have been going up at more than 20 percent.

Over the past two years alone, the average house has increased in value by about $20,000.

But Duncan of the Mortgage Bankers Association says that for the past year, the rate of increase has been slowing. At the end of March, it was down to about a 3.7 percent annual increase.

Still, it's the refinance market that is reeling from the rise in rates. Scott Messina, publisher of Originator Times, an online publication for the mortgage industry, says the "refi" market has experienced "one of the sharpest drops in its history" as activity dropped about 50 percent over the past month.

Now, he says much of the refinance activity is centering around adjustable-rate mortgages (ARMs), which track short-term interest rates. "Some people are still seeing their rates come down," he says.

In fact, some loan consultants are counseling their clients to just sit tight. Barbara McMullin, owner of Capital Financial Services in Santa Barbara, Calif., says she hasn't canceled any loan applications yet. But she figures the days of the "bottom fishers" are gone.

"The people who were just doing it to save $50 or $100 are not going to do it, because they can't," she says.