John M. Lee: Where are Interest Rates Going?

As most people involved in real estate know, interest rates have clearly increased the past two months. For a couple of years, many knowledgeable analysts have noted that interest rates were a good deal lower than they would otherwise be because the Federal Reserve Bank, with worries about the financial markets because of possible deflation or a double-dip recession, was keeping rates artificially low.

The Fed was doing all it could in order to make money as available as possible to recovering businesses and to real estate transactions so as to not further depress a weak economy.

The overall market understood and agreed with what the Fed was doing, for the most part, so rates descended to record low levels and we benefited from fixed rate loans well beneath six percent for quite a bit of time.

Two important changes have occurred, however. First, there is increasing consensus and confidence that the economy is gaining strength. Second, the federal budget deficit is reaching all-time highs. This means we are forced to auction off more treasury securities at a time when there are fewer anxious buyers for those securities.

In order to sell them, therefore, the price has to go down, which means yields or interest rates have to go up.

So interest rates are at long last rising to the level dictated by that reality, rather than being held down by the Fed's manipulations and market worries. Investors are more inclined to buy stocks, even dot-com stocks again, and to invest in companies that will benefit from a sustainable economic recovery.

It also means interest rates have risen, with the 10-year treasury note (which long term mortgages tend to track) rising from 3.1 percent in mid-June to about 4.3 percent as of late September, thus leading to about a one percent increase in mortgage rates during the same period.

The question today is how high interest rates will rise. We can expect them to rise a good deal further if the economy heats up considerably. We will need evidence that the manufacturing sector has pulled itself out of the doldrums, that hiring is at long last outpacing lay-offs and that inflationary pressures are building up.

By all accounts, inflationary pressures remain benign. The rate for 2003 is expected to come in at around 2.2 percent, and most analysts do not expect the inflation rate to be much higher than 2 percent in 2004. This is certainly not the stuff of skyrocketing interest rates or of an overheating economy.

There is little reason, therefore, to expect interest rates to climb very high. A mortgage rate ranging between six percent and 6.5 percent, though higher than what we saw in recent months, is certainly not a high or unworkable interest rate, especially when viewed on a historical basis.

Understand that this rate is roughly a full percentage point above recent record lows and, therefore, the refinancing boom is declining. The number of real estate transactions, however, will ease, rather than decline steeply.

Demand for real estate remains remarkably strong and, so long as people can find a way to buy, it is apparent that they will continue to do so.

Currently, there are quite a number of innovative mortgage products in the marketplace and, depending on your personal situation, a traditional 30-year mortgage might not be the right option for you. A good mortgage broker or a savvy real estate professional will be able to help you decide the best mortgage product for you given your personal position.

John M. Lee is currently a top real estate broker specializing in the Richmond and Sunset districts. For real estate questions, call him at (415) 447-6231 or e-mail johnlee@isellsf.com.