Negative Equity and Rising Rates: Toxic Cocktail for Housing

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First came the surge in negative home equity, now a surge in mortgage interest rates. Add it up, and it throws a big pail of underwater on the hope for a big spring housing surge. At face value on their own, the two reports out today shouldn't cause too much concern, but the effect they have on consumer confidence is bigger than both of them.

The average rate on the 30 year fixed rate mortgage is now over 5 percent, which when you think historically is really a great rate, but that was then, and this is now. Consumer confidence and jobs are the two biggest drivers in the housing market.

"Because we had rates as low as 4.25 percent last year, any increase — particularly to above 5 percent — is likely to reduce loan applications as borrowers adjust to a higher interest rate environment," says Guy Cecala of Inside Mortgage Finance.

The biggest effect of course is in refis, which dropped over 7 percent last week, according to the Mortgage Bankers Association's weekly survey. Last year refis accounted for two thirds of all mortgage originations, so that will clearly change with the new rates. The question is how the rates affect home purchases. Purchase applications also dropped last week, but just by 1.4 percent.

"We are at the beginning of the spring buying season, but purchase volume remains weak on a seasonally adjusted basis," says the MBA's Michael Fratantoni.

Higher rates will make loans a little bit more expensive, but not all that much. The bigger driver of mortgage cost will be the new regulatory rules on the horizon and potential changes to Fannie Mae and Freddie Mac loan limits and fee structures.

But rising rates also put a bigger burden on those trying to modify or refinance troubled loans, especially those underwater. The new report from Zillow notes that the foreclosure freeze from the "robo-signing" scandal put an artificially high number of borrowers in the underwater pool because many were supposed to be foreclosed and weren't. Still, as I Tweeted yesterday from Laurie Goodman of Amherst Mortgage Securities, "Home equity is the single most important determinant of mortgage default, not unemployment."

Zillow's chief economist, Stan Humphries, agrees: "Once you get above 125-130 percent loan-to-value ratios, that means that you're 25 to 30 percent underwater on your house, at that point really you start to see a higher rate of strategic default, that's people actually feeling a sense of futility about making their mortgage payments and they walk away from the mortgage."

And how high will rates go? "I think if the 10-year Treasury yield remains at around 3.70 percent, mortgage rates will head to 5.25 percent over the next two weeks," opines Peter Boockvar of Miller Tabak. Again, that's still historically low.

"Realistically, long-term mortgage rates in the 5-6 percent range over the next few years would be affordable enough to support a “normal” housing market all things being equal," claims Cecala.

Unfortunately nothing in today's housing market is normal or even approaching equal.

Questions? Comments? RealtyCheck@cnbc.comAnd follow me on Twitter @Diana_Olick