Homes are very affordable just about everywhere, with prices far below peak levels of 2006 and interest rates still close to record lows. The question is what will happen if prices keep climbing and interest rates rise, which many economists think is inevitable.
One sure sign of a housing bubble is home affordability that’s considerably worse than long-term averages. At current interest rates, which are below 4 percent for the most creditworthy borrowers, no big city stands out as having a bubble. But prices are rising by double-digit percentages in some areas, which obviously makes homes more expensive. And if mortgage rates rise to 5, 6, or 7 percent — which is quite possible once the Federal Reserve begins to tighten its loose-money policy — it would harm affordability and possibly undercut the entire housing recovery.
Research firm Zillow (Z) has estimated what will happen in 30 big housing markets if mortgage rates rise. If rates hit 5 percent, six of those markets will have affordability worse than historical averages, qualifying as modest bubbles. At rates of 6 percent, the list swells to 11 cities. At 7.1 percent (the long-term U.S. average), bubbles would become more pronounced, and undoubtedly problematic. As the following chart shows, bubbles would be worst in San Jose, Calif.; Los Angeles; San Diego; San Francisco; Portland, Ore.; Denver; Riverside, Calif.; Miami; Seattle; and Sacramento.
Bubbles don’t always burst with catastrophic consequences but they do create distortions and volatility, causing wide swings in prices, for instance, or squeezing household finances. And when they do burst, of course, home owners who bought at the wrong time can end up owing more to the bank than their house is worth. Nobody wants a repeat of that.
Rick Newman’s latest book is Rebounders: How Winners Pivot From Setback To Success. Follow him on Twitter: @rickjnewman.