You hear a lot these days about how unaffordable housing has become in the US. One way to think about affordability is to look at home prices relative to household incomes. The common rule of thumb in the 20th century was that you should pay around three years of pre-tax income for a home. On that basis, housing has been unaffordable for the last 45 years when comparing median house prices to median household income!
The trouble with this analysis is that households are all lumped into the same group, whether they own a home or rent. The reality is that homeowners are richer than renters, and we don’t expect the median-income household to buy the median-price home. The median home-owning household has 28% more income than the median household. So, when dividing the median home sale price ($425,000 based on July 2023 data) by 128% of the median household income ($93,000 pretax) — you get a ratio of 4.6, which is more than 50% above the 3.0 rule-of-thumb. This version of affordability was the focus of stories in 2021 and 2022 when the ratio was spiking. In 2023, though, house prices are little changed while incomes have risen. The ratio of home prices to income is still quite high by historical standards, but well below the peak.
The current spate of stories about affordability adds another crucial factor: mortgage rates. Traditionally, lenders like to limit mortgage payments to 28% of pre-tax income. If a home buyer can find $85,000 to make a 20% down payment on that $425,000 median-price home, she needs to borrow $340,000. The current rate on a 30-year mortgage averages 7.23%, according to Freddie Mac, which means a monthly payment of $2,315. It would take a pre-tax annual income of nearly $100,000 to pass the 28% of income test.
The next chart shows what fraction of pre-tax income for a household earning 128% of the median is required to service a 20% down, 30-year-fixed mortgage at the national average rate on the median-price home. In the late 1970s and early 1980s, the income test was a big problem. As a result, lenders came up with adjustable-rate mortgages with low teaser rates and other tricks to qualify borrowers. They were willing to do this because they expected the high inflation of the time to increase borrower incomes rapidly so they could meet the higher payments down the road. Also, inflation pushed up home prices, so the lender had plenty of collateral cushion if it had to foreclose.
The chart shows that since the 1990s, the income ratio has not been the limiting factor for most home buyers. The higher hurdles were coming up with down payments and covering non-mortgage costs and in some cases losing the home mortgage tax deduction.
In 2023, though, increasing mortgage rates and home prices have made income ratios tougher to meet. Unlike the 1970s, neither borrowers nor lenders are confident elevated levels of inflation will continue, so both are reluctant to use tricks to cut initial mortgage payments, and the memory of the 2002 – 2006 housing bubble excesses is another argument against tricks. Plus, other expenses associated with housing such insurance and taxes are going up faster than incomes. And as shown in the first two charts, home buyers must allocate more years of income to a house purchase than has been considered prudent in the past.
Normally, if something becomes unaffordable to buyers, sellers must cut prices. So, we might expect the home affordability problem to correct naturally from market forces. Unfortunately, there’s a problem with that. Consider a hypothetical John Doe who bought a median-price, $300,000 home in August 2016 with 20% down and a $240,000 30-year-fixed 3% mortgage with a $1,012 monthly payment. Doe feels pretty good. The value of his house has increased to $425,000 — based on the median amount of appreciation — and he’s repaid $38,443 of the mortgage principal. The price increase plus the paydown means Doe has almost $225,000 in home equity. He thinks it’s time to use the increase to buy a nicer house. Doe wants to keep his mortgage payment the same and just use the surplus funds from the sale of his home to make a very large down payment.
Doe figures to clear $223,443 from a sale after repaying his remaining mortgage. To keep his current $1,012 payment, he can only borrow $148,622 in a new 30-year fixed 7.23% mortgage. That means he can buy a house for $372,065, which means he would be trading down and not up — and that’s before paying sales commission, taxes and expenses. In reality, he’s probably looking at more like a $325,000 house. His profit has evaporated and he’s actually down $100,000 in house quality. He’s also added seven more years of mortgage payments since his old loan had only 23 remaining years. Adding insult to injury, the Internal Revenue Service thinks he has a $125,000 profit, although he probably can avoid paying capital gains tax on the first $500,000 of gains if he’s married.
So not only are households with upper-middle-class incomes unable to afford to buy John Doe’s house for $425,000, he can’t afford to sell for $425,000 or anything near that price. There are sellers who are forced to move due to job change or divorce or some other life change, or who lose their houses in foreclosure, or who die, or who have paid off their mortgages, or had older, higher-rate mortgages and missed their chances to refinance. But these factors can take years to bring the housing market into balance.
If the market offers no immediate help, what about the Federal Reserve? The Fed might be done raising interest rates and might even cut them as soon as next year. That might bring down mortgage rates if lenders are confident the Fed cuts won’t reignite inflation. The lower rates could also stimulate the economy and lead to higher wages. If inflation stays low, house prices might not increase as much as wages.
But that’s hoping to win a trifecta. If the Fed must raise rates further to slow the economy, and if inflation remains stubborn despite the tightening, the housing affordability problem could get worse before it gets better. I’d say it’s a coin flip whether Fed actions make things better or worse. Federal and state governments could help, but I don’t see much prospect for major initiatives before the 2024 elections.
Most markets tend to equilibrium because higher prices encourage sellers and discourage buyers, so prices fall. But higher mortgage rates discourage both buyers and sellers, so home prices do not fall quickly. It can take several years to reach equilibrium unless investors and mortgage lenders decide that the Fed really has licked inflation and has the discipline to keep it in check, and Congress will moderate deficits. Then mortgage rates can fall bringing buyers and sellers both flocking anxiously to market.
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