Buying a Home has Become Unaffordable for Many. Will Falling Interest Rates be a Game-Changer?
As the COVID pandemic was unfolding in the second quarter of 2020, the median sale price for a home in the United States was $317,100. Last quarter, the median price was $412,300, down from a 2022 peak of $442,600. Depending on where you live, the situation could be better or worse, but few regions are immune to the surge in prices and the associated plunge in housing affordability. If you read my thoughts back in 2022, you may remember I was not a believer in an imminent “crash” in home prices. For those looking to buy today, I’m sorry to say that no such buying opportunity has presented itself. But the news isn’t all bad…(read to the end!)
The fact that home prices, like most assets, rise over time shouldn’t be a surprise to anyone. What has surprised many is the post-pandemic price surge that occurred without a proportional increase in wages. Many, especially first-time homebuyers without significant assets in the stock market or previously owned real estate, have found themselves in an untenable position.
How Did this Happen?
Like most extreme economic conditions, it’s impossible to point to just a single cause. For price increases this dramatic, it takes a confluence of events. Let’s review what unfolded in chronological order:
- The financial crisis caused by the subprime mortgage meltdown from 2007-2009 led to major changes in the number of homes built in America. There was a glut of housing at the time; much of it vacant. This left little economic incentive for homebuilders to construct new housing. Consequently, bricklayers, carpenters, electricians, and plumbers found themselves out of work. Many of them were forced to leave the industry altogether. These ripple effects are still with us today in the form of a critical construction trade labor shortage and too few new homes to support a growing population. Everyone needs a place to live. But there aren’t enough skilled workers to build those places. You’ve experienced this if you’ve renovated your home in recent years and found yourself haggling over price. The supply-demand dynamic does not work in your favor, and it certainly doesn’t favor first-time home buyers. If it costs more to build a home, then home prices must go up.
The chart below shows permits issued over the last 30+ years to build new homes. We’re still not building at pre-housing crisis levels!
- Governmental stimulus in the form of fiscal spending, low interest rates, and other consumer hand-outs designed to prevent a recession worked (almost) according to plan. But there was a catch. COVID-era inflation was exacerbated. This meant prices on nearly everything moved higher. This included residential real estate. It was a geyser of spending (red circle below) for what proved to be a tiny recession (gray lines indicate recession), but the government would argue that at the time, nobody knew what the outcome of the pandemic would be. Unnecessary spending (stimulus) coupled with historically low interest rates eventually led to higher prices (inflation).
Source: US Bureau of Economic Analysis www.fred.stlouisfed.org
- Interest rates are now higher than they’ve been in nearly two decades. This is the Federal Reserve’s way of curbing inflation through policy designed to slowly roll back economic stimulus. However, a very high percentage of homeowners today have mortgages obtained before rates increased. These rates are fixed, often for 30 years. Reluctant to give up a 2-4% mortgage rate for the 6-8% rates being offered today, many are refusing to sell. Refinancing, which is a forced event in a home sale, slows when interest rates are high, an inverse relationship. The chart below inverts the treasury rate (in orange) to show the correlation with refinancing activity. The recent spike in rates after an extended period of historically low rates has exacerbated the issue. Even those with good reason to move have held off. This means a smaller supply of homes for sale, adding insult to injury for first-time homebuyers. It’s not just the builders who have failed to supply new home construction, it’s also the homeowners in the existing homes unwilling to put a sign in their yard!
Home builders are unlikely to change their ways any time soon without government intervention, but the Fed has already signaled that changes to their policies are imminent. This could mean that those “hoarding” existing homes at rock bottom mortgage rates may soon be willing to move off the fence.
What Will Lower Rates Mean to Affordability?
There are two potential impacts from a move lower in interest rates. First, and most obvious, is that monthly mortgage payments become cheaper (for new or refinanced mortgages). For those unable to afford a new home, that’s great news. However, typically, when mortgage rates go down, the value of a home also goes up (because buyers can take on a larger mortgage balance for the same monthly cost). Here’s an example:
A $500,000 home purchased with a 20% down payment results in a $400,000 mortgage. Let’s look at a 30-year fixed rate loan.
If the rate is 7%, the monthly principal and interest payment would be $2,661.
However, if the rate was 3%, the monthly payment would drop to $1686.
That’s 36% less.
One might also say that this home just became 36% more affordable.
If rates dropped this dramatically (which is unlikely without a major recession), would that mean that a typical home would increase in price by 36% just because the rates dropped? It’s unlikely, because there are many other factors affecting home prices, and not all homes are bought with a mortgage. The “supply” of homes may also increase as homeowners who have put off selling finally feel they can do so without taking on a much higher mortgage rate. It is impossible to know exactly how a change in mortgage rates (which move based primarily on the 10-year treasury rate) will affect home prices. History gives us a guide, but like so many historical charts, the pandemic and ensuing stimulus has thrown so many economic dynamics out of equilibrium, that referring to them may be a fool’s errand this time.
What Should Prospective First-Time Homeowners Do Now?
I would argue that waiting until financial conditions are right to buy a home is a fruitless exercise. Buying a home is a lifestyle/family decision as much as it is a financial one. Finding the right home, in the right neighborhood, at the right time is more important than timing the interest rate cycle. Refinancing later, should rates drop low enough to justify it, is also an option. It’s important to note that current rates are more representative of the average mortgage rate over the last 50 years than rates of the COVID era were. So, if you’re waiting for rates to get back to “normal”, they’re already there! It’s as important to be realistic in your expectations when considering financing costs as it is to take advantage when lower rates are available.
The good news…your home value and income will go up over time. Your mortgage payment (assuming it’s fixed) will not!
