- The Washington Times - Thursday, December 29, 2005

As the year draws to an end, we can look back and see that 2005 was an interesting year in real estate and

mortgages. Let’s take a look at some highlights.

• The Federal Reserve raised short-term interest rates eight times, continuing its credit-tightening policy, which began mid-2004.

The prime rate increased 2 percent, from 5 percent to 7 percent. Short-term mortgage rates, such as monthly adjustables and home equity lines of credit, followed the Fed’s actions in tandem. Folks with these types of loans were impacted the most.

• Long-term rates, such as the yield on the 10-year Treasury bill, only inched upward, from 4.22 percent in January to its current yield of 4.45 percent. Long-term mortgage rates generally follow the 10-year Treasury note.

Looking back in my records, I see that I was quoting 5.875 percent for a 30-year fixed-rate loan in January. Today, I’m quoting 6.125 percent, just a quarter percent higher.

• The breathtaking pace in real estate values finally has ebbed. Over the past year, I wrote a couple of columns about the frenetic pace of the Washington area real estate market. Until just a couple of months ago, offers that included price-escalation clauses were the norm. Homes were sold within a week, some within a day. Today, the same subdivisions that were selling homes within a few days are littered with homes sitting on the market.

• The sharp rise in real estate prices with the absence of an equal rise in income made homeownership more difficult to afford. The steady drop in mortgage rates from 2000 to 2003 partially offset this imbalance, but as rates began to rise while property values continued to rise, more and more potential homeowners were squeezed out of the market.

It doesn’t take a rocket scientist to explain the explosive popularity of the interest-only and negative amortization mortgage products, which allow a borrower to afford a larger loan with the same income.

Now let’s take a look at what we may be seeing in 2006. Remember, I’m not making any predictions, just offering speculation.

• Economic numbers are satisfactory, according to most economists and government officials. Inflation is contained, and the outlook for economic growth and corporate earnings is good. However, some argue, and rightly so, that the spike in real estate and energy prices will cause economic damage even if the so-called “core” inflation remains contained. Time will tell.

• As I mentioned, short-term interest rates have risen by roughly 2 percent while long-term rates have moved barely a quarter percent. This “flattening” of the yield curve is an uncommon but not unheard-of phenomenon.

When short-term rates exceed long-term rates, we have an inverted yield curve. There’s one problem. History has shown that a recession often follows a period with an inverted yield curve.

When a recession hits, interest rates are likely to drop. As I said, time will tell.

Let me speculate on the outcome of the interest-only loan popularity. If you believe everything you read and hear about them, you might predict that half of all homeowners will go into foreclosure in 2006.

Here’s my take:

• If interest rates rise in 2006, interest-only programs will continue to be popular simply because the products enable more folks to afford a home, especially in pricey areas such as Washington.

• Most folks who took out interest-only loans in 2005 purchased a property for the long term or refinanced a home that already had thousands of dollars in equity. Moreover, most of these folks took out loans that carry a fixed rate for the first seven or 10 years — long enough to ride out a temporary lull in property values. These folks are going to be fine.

• The folks who hopped on the real estate bandwagon and obtained 100 percent financing on an interest-only loan with the plan of flipping the property in a year for a huge profit can certainly get in trouble.

Highly leveraged financing coupled with short-term speculation creates the risk far more than an interest-only loan.

Stay tuned: 2006 is sure to be as interesting as 2005.

Henry Savage is president of PMC Mortgage in Alexandria. Contact him by

e-mail ([email protected]).

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