It sure was fun while it lasted, wasn’t it? A new president, promises of deregulation and new tax cuts tickled the stock markets for 16 months. Now, there’s a wall of worry being built based on the threat of a trade war with China, Middle East turmoil and, instead of deregulation, new regulations on technology companies that may slow the exuberant gains the highest-flyers have achieved.
There is an underlying aspect to all of this that I think plays a much bigger role than these transient events — interest rate changes and how they affect prices in a much bigger way than a tax on Chinese-made electronics. For the biggest purchase of your life, your house, the real determinant is no longer “location, location, location,” it’s “rates, rates, rates.” The housing market’s sensitivity to the rise and fall of interest rates is well known, but the interest rate — and the direction the market will turn when rates change — remains a little more mysterious and, as we head into a period where rates are going higher, this concept may be more important than any other indicator for investors and their money.
To better understand the impact of interest rates on the stock market and home prices, one needs to understand the time value of money concept (it's ok to read on, this is not a math lesson). The time value of money simply means that, in most cases, the value of a dollar received today is greater than the value of that same dollar received in the future. This is because I can do something now with the dollar I receive today (like invest it) whereas I obviously cannot do anything today with a dollar received in the future. I can calculate the present value — the value today — of that dollar received in one year using an interest rate of 3 percent. The result is the value today of the dollar received in one year using a 3 percent interest rate is $0.97. Voilà. The time value of money in this example is 3 cents.
Now you may be asking how I arrived at 3 percent. The answer yields the second key to understanding the time value of money. This interest rate you use to perform the present value calculation (called the discount rate) determines the time value of money. If I use a 10 percent discount rate instead of three, the present value of the dollar received in a year is $0.91. This is because using 10 percent assumes a much greater benefit if investing it for a year.
The discount rate also functions as a measure of the risk of not actually receiving that one dollar in one year. For example, if you lend someone $5,000 for a risky venture that you may not get your money back on, you charge a higher interest rate. This makes the present value of that risky loan today a lot lower than $5,000. Banks use the interest rate charged on loans, among other things, to distinguish between risks.
Related: Why Fear of Inflation Is Rattling Investors
The value of a measure of stocks, like Standard & Poor’s 500 index, is nothing more than the present value of the expected future earnings of all of the companies in the index. The stock market has been struggling recently because interest rates are rising and with it the discount rates used by a multitude of analysts, bankers, traders and individual investors. Projected revenue and earnings may be impacted by the cost of money for the company and the people who buy their products. Like I said, the direct impact of rising interest rates can depend on the products a company sells, but it has other effects ranging from the cost of borrowing, the revenue they receive from investments and any drops in sales they experience from customers who have less money to spend.
As for home prices, using what you know of the time value of money, you know that if mortgage interest rates rise you can borrow less (for a given level of income). And you know why — because the bank is using a higher discount rate on your future payments because of the higher interest rates. Mix in economics 101 — if you have less money available to spend on a house, what happens to the value of the house? Exactly; it drops.
To be precise, a rise on a 15-year $100,000 loan from a rate of 3.75 to 4 percent would add $64 to the monthly payment. If rates jumped to 20 percent, the cost of money in March 1980, the monthly payment for the $100,000 house would increase by more than $1,000 a month, and a lot fewer $100,000 homes would be sold, as well as cars, vacations, food and the jobs that go with them. It’s no wonder, there were a lot of grouchy people back in the Spring of 1980 (they also had to pay more than a dollar for a gallon of gas for the first time since cars were invented).
So, while we are easily distracted by threats of tariffs and retaliation, it will be important to keep an eye on interest rates that start this process for financial markets, the prices for homes and virtually everything one borrows money to purchase or do, including buying stocks. I am not alone in being concerned about higher interest rates, but when they rise, based on these formulas, we all have a good idea of what to expect and why.
Related: With the Fed Easing up on Quantitative Easing, Prepare for a Whole New Market