Rising mortgage rates, and the affordability gap
By Don Ganguly
Rising interest rates have a great impact on affordability of single family homes. But what types of buyers and investors will face the greatest headwinds? And what locations will fare better than others?
Mortgage interest rates hit historic lows of 2.65 percent in January 2021 as published by the Federal Reserve Bank of St. Louis, and have been rising steadily since. As of early mid-April, they tipped past 5 percent, up almost 2 percent in the last two months.
In many metro areas, households earning today’s median income would have a very difficult time affording a house priced at the median. And rising rates are threatening to make that gap even wider.
The number of new units builders have in the pipeline over the next few years will be a mitigating factor to the supply crunch and the steep price escalations of the last two years in the hottest markets across the country’s Sunbelt, including Las Vegas, Phoenix, Austin, Dallas, Atlanta and Tampa.
Looking at median incomes, and median prices
To analyze the impact of the current higher interest rate on affordability, the first question to look at is whether the national median income can afford the national median home price.
For this analysis, a 20 percent down payment on a loan that conforms to Fannie Mae standards is assumed. Most Fannie Mae loans can be no greater than 28 percent of the borrower’s gross income.
This assumption requires that the income required to afford the loan payment with an 80 percent loan-to-value, i.e., a purchase in which the home buyer puts 20 percent down. The payments also include estimates for taxes and insurance.
According to statistics from the United States Department of Housing and Urban Development, the median family income was $79,900 in 2021. So, at a national level, the median income cannot afford the current median price of $392,000 at a 5 percent mortgage rate.
If rates climb further, this gap will widen.
Doing the same math in some major metros, assuming a 5 percent interest rate and 20 percent down payment, yields these resultIn 11 of the 21 metros (in red), a household would need an income higher than the national median to be able to afford a house in the median price range.
As expected, many of the higher-priced coastal markets have a greater level of income-to-home price mismatch, which has created affordability problems that are quite extreme in some cases, with prices outstripping incomes by more than $100,000.
In Los Angeles, for example, the median income is not even $81,000 and the median home costs around $815,000. San Francisco has a median income of not quite $126,000 and a median home price of over $1 million.
Metros in Dallas and Atlanta are currently on the cusp of this affordability line. As rates rise, more of the 20 metros may also become more unaffordable.
What about the first-time home buyer?
The first-time home buyer cohort is struggling in the current market. Per Zillow, first-time buyers accounted for only about 27 percent of home purchases in January 2022, down from 43 percent in 2020 and 37 percent in 2021.
Millennials are a big percentage of first-time home buyers as they settle down and build families.
The same affordability analysis appears below (at a 4.8 percent mortgage interest rate) with the median price of the most affordable one-fourth of homes in the metros as a substitute for the entry-level home price.
For this analysis, FHA loans were considered, which are designed to help first-time home buyers who may not have saved enough for a 20 percent down payment; they allow borrowers to get in with only a 3.5 percent down payment.
FHA loans will fund a maximum home price of $420,680 for single family homes in low cost areas. In high-cost areas, that amount rises to $970,800. These borrowers, however, have to pay an insurance premium that gets tacked on to the monthly payments.
FHA loans are slightly more generous, going as high as 31 percent of the borrower’s gross income.
In 11 of the 20 metros, the median income cannot afford a starter home with an FHA loan. This is partly because of the lower down payment requirements and the insurance premiums that get tacked on to the monthly payments.
This presents a Catch-22. Entry-level home buyers cannot afford higher-priced homes as they may not have enough saved for a down payment. On the other hand, they can’t afford entry-level homes either, because if they put down a smaller amount, the payments are higher.
Both scenarios are exacerbated by the high home prices in these markets.
Unfortunately, for first-time home buyers, this price range represents a fiercely competitive segment of the market, where inventory is tight and prospective homeowners are also competing against investors, many of whom pay cash.
Median existing home prices rose 15 percent year over year to $357,300 in February 2022, according to the National Association of Realtors. Average prices in major metros were up by 19.2 percent year over year in January 2022, as reported by Case Schiller.
But pay increases are nowhere near keeping up even with an annual inflation rate of 8 percent, to say nothing of keeping up with home price escalation. Per Payscale’s 2022 Compensation Best Practices report, only 44 percent of employers are planning to give employees a pay raise of 3 percent or more. March data reported by the Wall Street Journal shows a 5.6 percent hourly wage increase year over year.
A number of new homes are expected to come to the market in the next few years and should ease the supply crunch.
According to John Burns Real Estate Consulting, builders have 1.2 million housing starts and 1.2 million permits in 2022, a trend that is likely to continue over the next few years, as Freddie Mac estimates the country is somewhere around 3.8 million homes short of demand.
If interest rates push past 5 percent, demand for homes is likely to be curtailed, and continued inflation may cause a recession instead of the soft landing the Fed is trying to achieve.
If these two factors cause home price escalation to soften but not so much that prices fall and existing owners delay selling their homes. Recent surveys have shown that 6 in 10 prospective sellers expect to put their homes in the market in the next 6 months, as some fear that rising rates will make it too late for them to cash in on higher valuations.
For now, some aspiring homebuyers may have to rent single family homes till the home buying environment normalizes.
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In the meantime, learn more about ways to start with a smaller downpayment here.