The Biggest Threat to Home Prices
A decade after the United States hit its real estate bubble highs, home prices are approaching and in some cases surpassing amounts that we all agreed (albeit in retrospect) we’re unsustainable. How home prices can be higher than they were in a bubble despite wages being lower, fewer people working, and less demand (as evidenced by the percentage of home owners) is a bit of mathematical magic that we’ll save for another article. But the main culprit behind this rise in home prices could also be the biggest risk facing home owners in the coming years: Interest rates.
The US Federal Reserve began lowering its funds rate to a record low of 0.25 percent in December 2008.
The move, and subsequent interventions including Operation Twist and QEs 1-3 were designed to stimulate economic activity by making it cheaper for business and individuals to borrow (and thus spend money). It worked. As the Fed’s fund rate dropped, so did the yield on treasuries and by extension the interest on many loans, especially mortgages.
So why should you be scared? Declining interest rates mean that it’s cheaper to borrow. That’s a good thing right?
Well it is when the price of the item you’re buying hasn’t changed. So if you already have a mortgage, student loan, or other debt, by all means, refinance at a lower rate.
However, if you’re looking at buying a home, you may want to reconsider because the cost of homes have dramatically increased (I’d argue that it’s in bubble territory) to account for the cheaper cost of borrowing.
The simple fact is that most people who purchase a house don’t have any idea whether they can afford a $400,000 house versus a $600,000 house. Humans are really, really bad with large numbers and trying to comprehend a mortgage that’s equal to a decade of work (pre-taxes and not including any other expenses!) for the average household income is impossible. So we put the mortgage in terms we can understand: Monthly payments. Suddenly, those houses we mentioned earlier become a decision between a $1,703 payment and a $2,554 payment (based on today’s interest rates of 3.36% and the average down payment for first time home buyers of 3.5%). All we had to do was only look at 1/360th (i.e., one-quarter of one-percent) of the total loan (12 months of payments over 30 years) and suddenly that house looks like a great deal!
Here’s where you can get into trouble and why home prices have reached unsustainable highs despite seeming affordable when only looking at the monthly payment: Interest rates.
Say I can afford, based on the monthly breakdown that we discussed above, a $2,500 a mortgage payment. It doesn’t matter to me if the house is $400,000 or $600,000 – again I can’t even comprehend numbers that big – all I care about is whether I can make my monthly payment based on my budget. So, how much home can I afford on a $2,500 budget? Answer: It all depends on the interest rate.
As you can see in the chart I created above, over the past 15 years, how “much home” you could purchase for a $2,500 budget varied wildly based on what the interest rate was at the time of your purchase. Since Oct. 2008 alone, the value of a home could’ve increased 40% ($555,000 from $395,000) accounting for interest rates alone.
Why does this matter? Because, despite recent history, mortgage rates can go up just easily as they can go down. If I can only afford $2,500, I can only afford $2,500. And if I can no longer afford a half-million dollar house because interest rates have increased my monthly costs, I’ll either have to sit out from buying or the price will have to come down.
If interest rates go up just one percent, a $555,000 mortgage goes from costing you $2,500 a month to $2,800. Another 1 percent bump (bringing us to levels seen less than a decade ago) brings the mortgage’s monthly cost to $3,151. There are a lot fewer people who can afford a $3k/month mortgage than there are that can afford $2.5k/month and prices will have to come down to accommodate the smaller supply of buyers.
Interest rates could continue to fall – we’ve seen it in Europe and Japan, but my money is on them returning to where they once were rather than entering uncharted lows. Watch for home prices to quickly follow suit.