Today’s Housing Is At Record Affordability, If You Can Afford To Buy A House

By David Rosen, Residential and Commercial Real Estate Markets Advisor

There is a massive disconnect in today’s U.S. single-family housing market. Nationally, home prices adjusted for inflation and relative to household income are at record highs, yet housing affordability has not accordingly reached record lows. This is, of course, a national view and does not highlight the wide variations in affordability and housing price performance that occurs at local levels. Many local markets face acute shortages, but we will focus on national trends in this article.

Looking at historic data, the week of October 9th, 1981 is where the disconnect starts. The average 30-year fixed rate mortgage issued that week carried an interest rate of 18.6%, a record high. While 1981 saw extremely high interest rates, as the Federal Reserve had raised rates to fight inflation, a 30-year mortgage never averaged below 7% from April 1971, when the Federal Reserve started their tracking, until August of 1993. Even after 1993, it was not uncommon to see rates above 7%, that is until January 2001. However, mortgage rates have been on a long downward trend, and even in the housing boom of the mid- 2000’s, rates never topped 7%. This trend continued post Great Recession, with the highest weekly average reaching 4.9%, creating the paradox.

There are two major financial components that concern home buyers. One is the down payment and the second is the monthly payment. As housing prices increase, the 20% down payment typically required to buy a house increases, not only in absolute dollar amounts, but in relative amounts compared to annual income. Thus, houses theoretically are becoming less affordable over time. However, as interest rates have declined, the monthly payment has decreased. For most mortgages, especially in the early years, the major portion of the monthly payment is the interest on the loan. When interest rates are lower than historical rates, then the monthly payments are lower as well. Therefore, houses are actually becoming more affordable over time.

In the graph below, we have highlighted the two major considerations that most people make after they decide they want to purchase a home; how much will it cost per year in mortgage payments, and how much money do I have to put as a down payment? Both of those factors are shown in Figure 1, as a percentage of median household income. The traditional mortgage payment to income ratio is calculated holding the down payment steady at 20%, which usually the minimum down payment needed to eliminate any Private Mortgage Insurance (PMI). In the 1980’s mortgage payments as a percentage of median household income were regularly projected to be 30–40% of median income. Steadily dropping in the 1990’s, these payments reached about 25% of income. They rose during the 2003–2006 housing bubble, but since 2009 have been at all-time lows, hovering between 20–25% of income. Before 2000 a 20% down payment was fairly consistent at about 80% of income. Today a down payment is regularly over 100% of median income. Figure 2 shows the ratio of down payment to monthly mortgage payments consistently rising, highlighting the consistently growing divergence between the two components of housing costs.

Figure 1

Figure 2

So, have rising asset prices, caused by falling interest rates, made homeownership unattainable? After all, it doesn’t help you to have an affordable monthly payment if you don’t have the down payment! Yes, it is no doubt true that some buyers have been locked out of homeownership, but not the vast majority. The most affected demographic usurpingly are young home buyers, who are the least likely to have been able to save the down payment for housing. Older buyers, who have used down payments from existing properties they own or who have with the passage of time saves a larger amount of money, have actually seen homeownership rates rise over the last four decades. There are ways to overcome these rising down payment requirements though.

Figure 3

The most common way to reduce down payment requirements is through the use of Private Mortgage Insurance (PMI), which allows a buyer to pay a premium on the market interest rate of about 0.5% in order to reduce the down payment requirement to below 20%. Using PMI, down payments on FHA loans can be as low as 3.5%, and 0% down payments exist under some special programs such as VA loans. According to the National Association of Realtors, over 60% of first-time home buyers put down less than 6% in 2017! And when housing markets are strong, and prices up, these numbers tend to rise. Figure 4 shows the median monthly payment to median household income if we limit the down payment to 85% of median income. This was traditionally the high-water mark before 2000. When using this formulation, we see payments have been much steadier as a percentage of income since the early 1990’s and masks the large divergence in monthly payments and down payments we have seen when looking at the raw numbers.

Figure 4

Lastly, let’s explore what we believe future rates will hold for the housing market and affordability. If rates decrease at a rate that follows the trends of the last 30–35 years, we expect that mortgage rates could hit 2% by the middle of the decade. 10-year treasury rates would sit about where they do today, at 0.5–0.6%. These rates have already become normal in most of Western Europe and Japan. Mortgage spreads would then be about 1.4–1.5%, which is the long-term average spread. If this happens, we do worry severe distortion in the housing market could occur. We run a scenario assuming that mortgage rates fall to 2%, and that the median mortgage payment stays at 23.8% of median income with 20% down to get to our baseline scenario. The 23.8% raw median mortgage payment is the average over the last five years, which we believe is a good indication of a moderate recovery based on relatively loose credit, and a scenario that should be expected going forward because of global economic and domestic demographic headwinds. We then limit the down payment to 85% of the median income, and the remainder of the purchase price is financed. Because the down payment limited by income is less than 20% of the projected future home prices, 0.5% is added for PMI payments. As you see in Figure 5, we expect asset prices to increase substantially under the lowered interest rates. This is seen as a 20% down payment (a proxy for the home price) rises to 134% of median income. However, using PMI we see that housing stays affordable, with payments rising to 28% of median income. This is on the high end or normalized market conditions, but well below the 2006 housing bubble high of 34%.

Figure 5

Figure 6

As we have seen, housing prices continue to rise to record levels, pushed ever higher by falling interest rates. While this increases the traditional 20% down payment into unaffordable levels for many, the use of PMI, whose cost is increasingly offset by record low interest rates, has kept housing affordable. Continuously lower interest rates should continue the trend of ever higher prices, with affordability coming from cheap financing. This creates tremendous housing wealth for existing homeowners, the same type of wealth many families tapped to propel our consumer driven economy in the mid-2000’s. However, as we reach such low interest rates, the question needs to be asked, what is the lower band for interest rates, and what happens to the housing market if we cannot continue to push up asset prices through this mechanism? Will the housing investment for many families still make sense? A trusted analytics partner can help you answer these questions.

About Hilgard Analytics

Hilgard Analytics is a socially conscious real estate and economic development research consultancy offering services in residential and commercial real estate, sectoral employment, economic and workforce development, demographic research, and geographic information systems analysis. Email us at Hilgard.Analytics@gmail.com for a quote today!

About the Author

David Rosen, the Residential and Commercial Real Estate Markets Advisor, at Hilgard Analytics, has a proven track record of success in the real estate and automotive industries and currently works full-time at Mazda (North America) as a Senior Analyst in the CPO Repurchase Promotions Department. At Mazda, has has become a leader in terms of providing excellent customer service, advising management on various regulatory issues, and vehicle lifecycle management.

David is also the Founding Partner of a real estate investment company specializing in repositioning distressed assets in walkable communities that exist in America’s most underinvested in neighborhoods. He has a lifelong desire to make the cities we live in more equitable and prosperous and has the ability to generate unique insights from his background in data analytics and knowledge of architecture and urban planning.

He holds a Bachelor’s Degree in Finance from California State University, Fullerton and an MBA from the UCLA Anderson School of Management.