With mortgage rates at 20-year highs and home prices higher than ever, housing affordability has plummeted. Everyone from renters to potential buyers will have a tough time trying to afford a living space. Some say the housing shortage is to blame as greater demand pushes home prices up and others may say rising interest rates are the root cause of declining affordability.
Higher rates and higher prices certainly would decrease affordability, but I ask which should take more of the blame?
If you are like me, visuals are much more helpful than a simple calculation. So here I’ve made the ratebow weighing home prices against rates and highlighted five budget points on the chart ranging from 1500 to 3500 based on the calculated payment as rates move up. For instance, we can see how rates impact the size of a mortgage a buyer can afford as rates change. A $3000 mortgage budget with 6% rates can nearly afford a $500,000 mortgage. However, if rates move up to 7% that same payment affords only $450,000 mortgage. If rates moved down to 5% that same $3,000 payment can afford a $550,000 mortgage.
But what if home prices and interest rates change? “What matters more the rate or the price?” Let’s look at an example to get some more ways to use the ratebow.
Get to know Bob the buyer:
Bob’s current house has a market value of $250,000.
Bob’s current Mortgage is at $200,000
Bob’s house is 1700 sq ft.
Approximate cost per sq ft: 147 (Market Value / sq ft)
The Decision:
Bob wants to move to a bigger house, but rates are so high Bob just can’t do it. Bob cried as rates went from 6% to 7.5% over the next year, but during this time the home equity grew from 50,000 to 100,000. Bob has always thought 20% down was the way to go and is now eyeing a $500,000 house using the home equity. Bob asks what would a $400,000 mortgage at today’s rate of 7.5% cost? Using the ratebow, Bob sees this mortgage costing roughly $2800 per month.
Now after the move Bob wants to know if waiting was a fiscally good decision. The mortgage is within the budget, but could it have been better?
For the sake of math, let us assume the price per square foot on Bob’s new home rose at the same rate the old home rose, we can see his new house would be about 2800 square feet. Had Bob pulled the trigger and purchased a 2800 square foot house back when rates were 6% the average price per square foot was $147, and the house would have been valued around $411,600. If Bob used his $50,000 in equity as a down payment before rates moved up, he would get a $361,600 mortgage for the same 2800 square foot house and Bob’s mortgage payment would have been $2,150 or $650 less. (not including insurance, taxes, or brokerage commissions or any underwriting tricks on any transactions)
So, what is more important in determining mortgage payments, rates or home prices? Hands down it was interest rates. When the price per square foot rose 19.7%, and interest rates rose 25%, mortgage payments increased by 30%. We can see that even if home prices stayed flat, the cost of interest accounts for $400 of the $650 increase in monthly payments. Even with the sharp increase in his buying power from his home equity, it was not enough to keep up with rates.
What if home prices continued to rise and rates stayed flat, how high would your home equity need to go to make a dent in the new mortgage payment? For the sake of math let us assume all home prices rise at the same rate. So, unless you are expecting to buy fewer square feet, your mortgage payment will still be moving up. From Bob’s example, we can see that rising home equity compounds with more square footage. So, in Bob’s position holding onto his equity would only help if he planned to buy fewer square feet. However, if Bob knew home prices would continue to rise, it would be in his best interests to hold onto his larger house until he expected them to stop growing. That way Bob could maximize his compounded growth by square foot before downsizing. However, if Bob is planning to use his home equity to buy a bigger house after it has grown. The principle of compound interest per square foot may push his payments beyond his budgeted mortgage payment amount.
What if home prices climb and interest rates fall, what rate gives the same payment as a “pre-climb” mortgage? For Bob to get the same payment, rates would have to fall below 5% for that mortgage to break $2,200 on a $500,000 house. In other words, rates would have to fall 250 basis points (2.5) or 33% to offset the steep climb in home prices.
So, what can Bob do?
There are four keys to unlock mortgage affordability. The first and most obvious is to make more income. With more income a higher mortgage payment can become more affordable. However, if you’ve experienced a market like Bob’s (i.e., the past year and a half) most people have not gotten a 30% raise in take-home income. You say, “alright then, what’s the second key?” You could try waiting for rates to come down or even plan to refinance if you expect rates to come down, but that could be a slippery slope. Over the last 20 years rates have taken around 3 years to move down more than 2% during non-recessionary periods. The only periods where we see accelerated rate declines are months before a recession and during a recession. Outside of these windows, rates tend to stay within 1 percent of the 52-week high.
So how can buyers unlock affordability if they can’t time the rates or control housing costs? That brings us to key number three. Adjust the price point a buyer is going to purchase. The drawback to this key is that you would be buying a smaller house than what you could once afford. So, for someone like Bob this does not sound as sweet as miraculous interest rate decreases. There is however one more key someone like Bob can deploy to maximize their home buying power. Check out the article here to learn how we can take control of home affordability.
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