The worst-case scenario for housing if the debt ceiling is breached
Mortgage rates could skyrocket if the U.S. government defaults, housing analysts say.
Democrats and Republicans have two days to reach a deal before the government breaches the debt ceiling. Should a default occur, mortgage applicants could face a worst-case scenario that includes rates that rise by as much as one to two percentage points within a day or so, says Stu Feldstein, president of mortgage-research firm SMR Research. “Interest rates would go through the roof immediately,” he says.
In order for such a spike to occur — and last more than just a few days — several scenarios would have to play out. Besides defaulting on its debt, the U.S. government would have to signal that it isn’t planning on making its payments soon or it would have to take the position of not intervening to stabilize the mortgage market. Analysts say complete inaction is unlikely since a severe increase in rates would lead to a drop in mortgage applications that would stall the housing recovery.
Andy Dean Photography / Shutterstock.com Home buyers, however, should be aware of the link between a government default and mortgage rates. A default would lead to an increase in Treasury yields, which serve as a benchmark for determining rates on many mortgages. The Treasurys impacted first would be those with the shortest-term duration—which would make adjustable-rate mortgages more expensive for borrowers, says Brad Hunter, chief economist at Metrostudy, a housing market research and consulting firm. These loans are given to borrowers with an initial teaser-like rate, which is normally fixed for a number of years; once that rate becomes variable, it’s often pegged to the one-year Treasury yield. That yield has barely budged in the last couple of weeks, though experts say a default would send it climbing.
On a smaller scale, some private banks and wealth management arms of large banks offer one-month ARMs, where the rate is fixed just for the first month and can then move in tandem with the one-month Treasury. (In the last few years this loan has been available to a limited number of mostly wealthy borrowers.) Since Sept. 30 (the day before the government shut down), the yield on the one-month Treasury has risen by 0.22 of a percentage point to 0.25% (as of Friday, Oct. 11). The rise suggests market concern that investors holding these Treasuries will not get paid by the U.S. government in case of a default, says Keith Gumbinger, vice president at mortgage-info website HSH.com.
Long-term fixed-rate mortgages would be the last of the home loans to be impacted. The yield on the 10-year Treasury, in particular, is often correlated with the rates lenders charge on 15- and 30-year fixed-rate mortgages. To determine how high those mortgage rates could go, consider the difference between the average rate on 30-year fixed-rate mortgages and the 10-year Treasury yield, says John Lonski, chief economist with the capital markets group at Moody’s Analytics. That difference peaked at 2.8 percentage points during the recession, and it’s likely that a spread of at least the same size would kick in following a default, says Lonski. Currently, this spread stands at 1.53 percentage points, calculated as the 4.23% average rate on 30-year fixed-rate mortgages, according to Freddie Mac, minus the 10-year Treasury yield of 2.70%. Should the spread move from 1.53 to 2.8 percentage points, the average rate on 30-year fixed-rate mortgages would be 5.5% at a minimum, he says.
On a $300,000 30-year fixed-rate mortgage, a borrower who would pay roughly $1,472 a month at a 4.23% rate would end up paying around $1,703 a month at 5.5% — or around $83,160 in extra interest over the life of the loan.
Home buyers applying for a mortgage this week should consider locking in the rate lenders have offered them. This will allow applicants to hold on to the rate for at least 30 days, which would protect them from a sudden increase in mortgage rates. And given the uncertainty of what may lay ahead for rates, applicants might also want to ask lenders for a rate lock with a “float down” option: This allows applicants to tap into a lower mortgage rate should rates fall by the time they get to closing. To have this float down option, borrowers typically must pay a nonrefundable fee of roughly a quarter-percentage point of the total dollar amount of the mortgage, says Gumbinger. Rate locks can be free for the first month though typically cost extra beyond that duration.
By AnnaMaria Andriotis