The Housing Market May Be Too High

In Consumers
Housing Market

Over the last two months there have been stories by the NY Times discussing the healthy housing market and Bloomberg talking about the red flags associated with the housing market.  The reality of the situation with the housing market is that while there are aspects of the market that are truly national is scale, but the housing market itself is made up of lots of small local markets.  The national aspect of the housing market is related to the mortgage market.  Mortgage rates have been at a historic low for the last few years with a period where the rates did increase, but the 30-year fixed rate mortgage has dropped down to the current rate of 3.42% (the national average).  The chart below illustrates the rate for the last decade.

30-Year Fixed Rate Mortgage
30-year Fixed Mortgage Rates for the last 10 years (as of 9/29/16.

The overall rates were a bit lower back in early 2013, but after increasing about 1/2% in 2013, the 30-year fixed rate mortgage has fairly steadily declined down to the current rate.

The housing market is an interesting combination of factors.  First, there is the home price.  Second is the aforementioned mortgage rate.  Lastly, there are associated costs like property taxes, insurance and home owner association dues (to name a few things).  These three things combine into one basic fact about housing.  Housing is all about the ‘monthly payment‘.  There is an amount of money that people are able to spend on housing.  When a bank looks at an individuals’ (or a couples’) income and expenses the financial institution generally looks at a few ratios to determine if the buyer(s) qualify for a mortgage.  There are 2 debt-to-income ratios that lenders look at.  First is the ratio for the home being purchased –> all housing related costs (mortgage payment + mortgage interest + property taxes) / income.  The second ratio starts with the housing costs but also adds in other debt, like car loans and student loans to come up with another debt-to-income ratio.  This looks like this -> (mortgage payment + mortgage interest + property taxes + car loans + student loans) / income.  Most lenders are looking for a TOTAL debt ratio of below 43% in order to qualify someone for a mortgage.  There’s a lot more to the actual qualification process, but this is a key test.

Looking at and understanding the information above, if one of the components of these ratios change, then the housing market will be impacted.  For example, if there’s a huge property tax increase this ratio can be thrown off.  What’s most likely to happen moving forward is a change in interest rates, which is likely to make mortgages more expensive.  Here’s an example; at the current 3.42% interest rate, a $100,000 mortgage loan will cost an individual $445 per month.  Once the FOMC starts to raise interest rates this math will be changing.  If the interest rate increases by 1%, to 4.42% (which is still historically very low), this same mortgage will cost $502 per month.  This represents a 13.6% increase in the cost of housing in this example.  This will not have an effect on existing home owners with fixed rate mortgages, because their mortgage rate (and therefore payment) is fixed.  This will definitely have an impact on home sales though as the original $445 monthly payment at 4.42% will only be for an $88,600 mortgage.

The chart above as well as this chart below indicate that the mortgage rates that we are currently experiencing are most definitely out of the ordinary and have been for quite some time.  Once the mortgage rates begin to normalize somewhat, there is likely going to be a pretty big impact on the housing market in that home prices could either stagnate for a long period of time, or they could drop like they did after the financial crisis of ’07-’08.  The historic average mortgage rates had been in the 7-8% range for a long time and the $100,000 mortgage discussed above would have a monthly payment of between $665 and $734.

30-year Fixed Rate Mortgage to 1971
Chart of 30-year Fixed Rate Mortgages dating back to 1971

As of the second quarter of 2016, the average home price in the United States was $188,000 according to this chart on the Economist.  The whole ‘real estate is local’ expression is really evidenced if you look at housing markets like San Francisco (currently at $810,000) or New York (currently at $386,000) compared to Minneapolis (currently at $226,000) or Detroit (currently at $127,000).  An increase of even 1% will have a significant impact on the housing market and a higher increase will have a long term impact on the market.  When the Fed gets together in the their next 2 meetings to discuss interest rates, they are typically focused on extremely short term rates (like the overnight rate).  Mortgage rates are typically pegged to a 10-year government rate so while we should all think about and listen to the rate increase when it inevitably comes (and it will), we shouldn’t all freak out.

I will add in closing that if you’re thinking that you might be putting your home on the market, this might be a good time to think about it as rates are not likely to be better, which means that the price of your home may never be greater than right now –> again, this is highly dependent on your local situation, but from a national perspective, things are not likely to get better in the mid or long term.  The housing market is highly likely to get worse, at least for a period.  When the interest rates on the underlying securities that underwrite mortgages increases, the price of homes, at best will stagnate and are likely to decline.  This is going to be a normal equalization of the market.  There really isn’t a political solution and there will definitely be people advertising their solution to this “problem”.

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