The Second Stage Of The Home Affordability Crisis Is Well Under Way

The first stage of falling home affordability began three years ago, as falling inventories of homes for sale led to bidding wars and skyrocketing home prices. Declining inventory in the for-sale market has become the norm, and we're now seeing the same in the for-rent market too.

As prices and rents move higher, people must spend more of their cash reserves and more of their disposable income on housing. This has been ongoing for three years, but now it's going to get worse.

The second stage of falling home affordability began in January as mortgage interest rates jumped up from the low 3% level to what is now approaching the mid 5% range. When one looks at interest rates over the past fifty years, today's rates are still far below average, but today's buyers are now paying a higher rate than previous buyers going back to the beginning of 2009!

Today's post is going to put these two stages in context to help our readers understand why home affordability is plummeting and where the market is very likely to go from here. For those of you who remember the housing bubble from 15 years ago, this is NOT THAT!

Money For Housing

Here's a simple thought. If you have cash, you can spend it on a home. But if your cash reserves require you to use a mortgage to buy a home, then you spend money on a home, and money on borrowing money.

As mortgage interest rates change, the amount of money that you spend to borrow money changes, and we see this difference in the monthly mortgage payment. When mortgage interest rates rise (like they have done lately), you might think that it makes your mortgage payment higher, but that typically is not the case (as I explain below).

Follow along as we explore where mortgage interest rates have been, where they are now, and how home affordability is being eradicated during the current change cycle.

Mortgage Interest Rate History Graph

You can learn a lot from studying a 50-year history of mortgage interest rates.

The blue bars in the graph above plot the average monthly 30-year fixed mortgage interest rate since the beginning of 1971. The solid yellow line plots the fifty-year average rate and you can see that roughly 1/2 of the months were above that line and 1/2 of the months were below the line.

Perhaps the most intriguing trend is plotted as an orange-dashed line showing how since 1980, rates generally declined until hitting a market low in December of 2020. Let me tell you what this means and why we're now facing a multi-generational change in the housing market.

Anybody who purchased a home in the late 1970s or later, all the way through recent years, generally found lower mortgage interest rates when it was time to sell their home and buy another. If they applied their equity from the sale of their home to the subsequent purchase of the next one, the lower rates allowed them to "move up" to a better home while keeping their monthly mortgage obligation pretty close to where their last payment had been.

For fifty years, move-up buyers have been supported by falling mortgage interest rates, but I fear that those days are over. Interest rates are cyclical and there is plenty of reason to believe that we're now heading into an era of generally rising mortgage interest rates.

Rising mortgage interest rates mean that while move-up buyers will have the equity from the sale of their homes, they might be priced out of buying a nicer home because the cost of the home (and more importantly the rising cost of money) will price them out of the move.

I explained this in detail in a recent article which you can read by clicking this link: Home Ownership Is Radically Different For Millennials.

Recent Mortgage Interest Rates

The past 10 years have seen rates fluctuate from as high as 5% to well below 3% during COVID. The graph below plots the monthly average 30-year fixed mortgage interest rate for the past eight years through March of 2022 (but the red star shows today's rate).

For many younger people, this graph of the past eight years represents normal mortgage market conditions, but as we know from the prior graph, this graph is actually a picture of the best of times.

I broke out the final eight years for several reasons. First, to illustrate just how high the current 30-year fixed rate is today when compared to recent low rates. Second, to underscore a recency bias that I see in many real estate reports and videos that talk about rates coming back down to "normal." Today's rate is BELOW "normal!"

I'm the first to admit that I'd go broke trying to forecast mortgage interest rates, but history is very clear that these rates will not continue forever, and even that red star on the graph represents a huge discount from the average rate since 1971. It is my belief that rates will go higher and they will do so for an extended period of time, though I do expect fluctuations along the way.

How Rising Rates Impact Your Monthly Mortgage Payment

When mortgage interest rates rise, home affordability declines for the majority of homebuyers who finance their purchases. As rates rise, the amount of money a buyer can borrow declines, thus the buyer must either lower his expectations on what he can afford or bring more cash to the closing table (which is often prohibitive for many buyers).

The table on the right shows that a buyer borrowing $400K at today's rate (5.4% for a 30-year fixed-rate loan) can expect a principal and interest payment of $2,246 each month. As rates rise, so too would the payment for the same $400K loan. In fact, were rates to reach the fifty-year average, that monthly principal and interest payment would be 28% higher!

In reality though, as rates rise, it does not impact most buyers' payments, rather it impacts the amount of money they can borrow and how much home they can afford. Buyers have a tendency to max out the home purchase price based upon what the bank will allow them to borrow, thus rising rates don’t impact their payments as much as it impacts the price of the home that they buy.

How Rising Rates Impact Your Home Loan Amount

As mortgage interest rates rise, the amount of money a buyer can borrow (and thus how much home they can afford) declines greatly.

The table on the right shows the same buyer from above (who borrowed $400K at a payment of $2,246 monthly). Instead of increasing the payment as we did before, this table shows the reduced loan amount this buyer can borrow due to changing mortgage interest rates.

How Today's Rates Compare To The Market Bottom Rates

Oh to have the power of hindsight! Mortgage interest rates hit a lifetime bottom of 2.68% back in December of 2020, so those that purchased near that time borrowed money at phenomenal rates.

Today's rate is just over double that low of 17 months ago, meaning today's borrowers are paying twice as much for the right to borrow money as were those buyers who took advantage of low rates in December of 2020.

The table on the right provides some insight into what rising rates mean today versus the market low. Somebody who could have qualified for a $400K loan back then would have had a mortgage payment of $1,618 (P&I) per month. That same payment would only qualify for a $288K loan today, a decline of 28%. But that does not tell the whole story.

Assuming a ten percent down payment, that $400K borrower in December of 2020 was buying a $444K home with just $40K out of pocket. Today, that same home would likely sell for $520K, meaning today's buyer who can afford a $1,618 (P&I) per month payment would need $120K out of pocket to "afford" the home. Somebody who chose to wait just 15 months tripled their out-of-pocket cash requirements. The buyer who took advantage of the low rates 15 months ago now has $120K equity and that nice low payment of $1,618 per month.

The Decline Of Home Affordability

The final graph in today's report plots home affordability in Tallahassee with an adjustment for inflation. We adjust for inflation to uncover the real growth or decline in home affordability by comparing all years in constant money terms. In our case, we are adjusting all prices to 1991 dollars.

For those readers not in Tallahassee, I can tell you that this graph very likely mirrors what you would find in your market too, just the absolute values might be higher or lower. Focus on the trends of the values, they are most likely similar to your market.

In this graph, the blue bars plot the average home price (adjusted to 1991 dollars) and are measured on the left vertical axis, while the red line plots the average monthly mortgage principal and interest payment (measured on the right vertical axis). Note that the horizontal axis runs from 1991 through 2040, allowing me to use current information and a few conservative assumptions to forecast a dark future for home affordability.

The table on the left side of the graph shows my assumptions for both mortgage interest rates and appreciation rates in the future. This is an updated graph I published last year, and I had to adjust my assumptions for 2021 and 2022 because they were too low!

The crossed dashed-line shows where we are today, note how the red line (home affordability) has surged at its fastest rate ever to start this year. The horizontal dashed line shows how today's adjusted mortgage payment is now higher (less affordable) than all previous years with the exception of 2004 through 2008. Yet look how I project it moving forward!

Remember, all values in this graph are adjusted to 1991 dollars, so a buyer today is getting a better buy than a buyer in 2005, but worse than any buyer from the 1990s. Unfortunately, I project monthly mortgage payments will reach a new all-time high before the end of 2023 (and home affordability will continue to erode from there).

Two Market Forces Impacting Home Affordability

Home prices and mortgage interest rates are the two drivers of this forecast.

I do not see anything in the near future that would bring down home prices. Sure, it could happen in some local markets that are undergoing population declines, but the overall US population is still growing and we have been underbuilding America long enough to have dug a rather deep hole.

The minimum wage in many states has risen faster than the historic norm and we've seen construction costs rise faster than normal (and that is not even including the soaring prices due to COVID). Homes are not being built fast enough to fill the void in inventory, thus bidding wars are driving home prices higher at alarming rates. Home prices are subject to supply and demand, and we're likely looking at a supply imbalance for (at least) the next three to five years.

Mortgage interest rates could be manipulated lower than my forecast, though it is not likely with inflation now running higher than the Fed would like to see. I think my forecast for rising rates is very conservative, growing at just a quarter percent each year. Imagine this graph if rates were to reach ten percent over the next few years. Remember, rates have doubled in the past 15 months, it's not crazy to think rates could double again over the next five years.

My Advice Regarding Home Affordability

Though mortgage interest rates today are much higher than we've seen in recent years, they are much lower than what we've observed prior to 2012. Since you cannot go back in time, my recommendation is that you make a decision today on how to proceed forward.

If you own a home that you enjoy and that you can see yourself happy in it for the next ten or more years, you really don't need to do a thing. You might consider a refi or HELOC to take advantage of today's relatively low mortgage interest rates, but otherwise, you are good to go on housing.

But if you believe that your home won't be your best solution within the next few years, you'll be better off financially if you make the change today. Homes are cheaper today than they will be tomorrow, and you'll likely borrow money at a lower rate today too. Even if you have to bite off more than you'd like to chew for the short run, the investment and discipline you apply today will be well-rewarded in the future.