There is a connection between personal income and housing prices. If housing prices increase at a faster pace than income for any extended period of time, housing will become overpriced compared to the local markets’ ability to afford it and it will inevitably return to equilibrium. This means price declines… at least relative to incomes. Essentially, we can’t expect our homes to appreciate faster than the local markets ability to afford it.
The underlying premise is that we will spend the limit of our affordability when buying a home. This is typical in areas where the cost of housing is high. We stretch ourselves to get the nicest house we possibly can. Home buyers determine their home-buying budget based on a monthly payment in relation to their income. This is an attempt to draw the connection between affordability and prices, but income alone doesn’t determine affordability. The amount you can borrow, which is a combination of income and interest rates determines how much you can afford. Logically there are limits to how much any family can afford. In my experience in California, because house prices are high, home buyers are very commonly stretched to their borrowing limit. They simply just can’t buy more.
So when a buyer applies for a loan, generally they are told how much they are allowed to borrow based on lender guidelines, which follow quasi federal guidelines for insurability of these loans. As people shop for homes, they are always tempted by the nicer homes. In many cases, especially in high cost markets; they are still a little disappointed that they can’t get something nicer. Therefore, it is very common for home buyers to shop close to, or at the limit, of their affordability.
Robert Shiller, Yale professor and Nobel Prize winner, takes the position that long-term homes rise in value because of inflation, rather than some investment quality creating an intrinsic increase in the value of a house. In fact, he argues that as building technology and efficiencies improve, older homes decline in value relative to new homes. As rates go up and down, the amount of money available to be borrowed and spent on a property, rise and fall as well. For example, a $400,000 home is $2026 per month at a 4.5% interest rate. But if the interest rate is at 6.5% the monthly payment is $2528. That is nearly $500 per month more for the exact same home. This affects the number of people that can afford that home and undermines price strength. If interest rates rise, there will simply be less money available to be spent on homes, resulting in downward pressure on pricing. There are many factors affecting the price of any home, but affordability (available income) creates one significant force that puts pressure on house prices.
Interest rates and income determine how much you have to spend – this impacts housing prices. A house can’t appreciate beyond our ability to afford it.