The Exchange

Homes Get Less Affordable as Prices, Rates Rise

If you’re a homeowner, recent news about double-digit price increases sounds terrific. But for buyers hoping to get a great deal on a house, the window of opportunity may be starting to close.

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For the past several years, housing affordability has been at or near record levels. Three basic factors determine affordability: home prices, mortgage rates and household incomes. The optimal moment for buying a home now appears to have occurred in early 2012, when the median price was about $156,000 and the average interest rate on a 30-year mortgage was 4.2%. Mortgage payments for a typical family totaled just 12% of income back then, according to the National Association of Realtors (NAR) — the lowest portion since 1970, when the NAR started tracking such data.

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In the first quarter of 2013 it took about 13% of income to make monthly mortgage payments, still a very low percentage. But two recent developments are pushing that number substantially higher: rising prices and rising mortgage rates. “Affordability will weaken because higher home values are not good for buyers, and higher mortgage rates are not good for buyers,” says Lawrence Yun, chief economist for the NAR. “And people’s incomes are barely rising.”

Financial markets have mostly cheered the rise in home prices, since it suggests the economic recovery is picking up steam, and a stronger housing market will help it grow even more. In the latest Case-Shiller survey, for instance, home prices rose 10.2% from the first quarter of 2012 through the same period in 2013. That news helped push the stock market higher because rising home values make consumers feel more well-off and comfortable spending money.

Rising rates

At the same time, however, mortgage rates have risen by more than half a percentage point during the past four weeks, pushing the average 30-year rate to nearly 4%. Rates are rising as investors fret that the Federal Reserve could begin to curtail its aggressive loose-money policies sooner than expected; this could upend financial markets for a while, since Fed policies seem to have taken on Biblical significance to investors. If the Fed tightens, it will push interest rates up, for the same reason rates fall as the Fed loosens.

Even at 4%, mortgage rates are low by historical standards. But when combined with rapidly rising prices, this can quickly change the affordability equation for buyers. For a $300,000 home with a 20% down payment, for instance, the monthly cost of a mortgage at 3.5% would be $1,078. If that home appreciated by 10% and mortgage rates rose to 4%, the monthly payment would rise to $1,260, or a difference of $182 per month. That might not be a dealbreaker, but it certainly makes purchasing seem like less of a bargain and it could tilt a potential buyer who’s on the fence about renting.

For all the talk of a recovery, the housing market remains filled with distortions. Prices are spiking in several areas because many homeowners still owe more than their house is worth, meaning they’d have to take a loss if they sold it. That limits the supply of homes on the market, pushing up prices.

As prices rise, more “underwater” owners will sell but there will still be a shortage of homes because builders aren’t putting up enough new houses to meet demand. That’s happening because many homes are built by small, local developers that can’t get funding the way big homebuilders can.

Both the housing and stock markets, meanwhile, are propped up to an unknown degree by Fed policies that have clearly inflated values but have also caused a lot of uncertainty about what will happen as the Fed withdraws. Yun, like many other economists, thinks mortgage rates could easily rise another half a percentage point or so in 2013, which would further harm affordability. So we may be in the process of finding out exactly what happens as the Fed begins to exit. The first answer seems to be: Some things get more expensive.

Rick Newman’s latest book is Rebounders: How Winners Pivot From Setback To Success. Follow him on Twitter: @rickjnewman.

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