The general belief is that the extremely low interest rates we’ve seen over the past 10 to 12 years or so have been good for the affordability of housing. While in the short-term this may be true, by driving down a monthly payment for a given price on a home, the longer-term effect has been driving prices higher and higher and potentially creating a disastrous long-term impact on the affordability of homes.
Low interest rates and liberal lending standards have made large amounts of capital available to be borrowed for housing purchases. However, the effect of increasing the money available to the housing market is creating corresponding price increases or inflation. Therefore, the net effect of the increase in money available to ordinary Americans to purchase homes has simply driven the price up.
The American homebuyer buys a home based on a monthly payment rather than a selling price. So when a buyer is meeting with their lender to determine how much home they can afford the calculations are all based on income, expenses, and current debt. Those formulas will allow someone to borrow based on the money available in their monthly budget for a home purchase. If someone can afford $2,500 a month for a home the current interest rates will lead to a dollar amount they’re eligible to borrow for the purchase. And in most cases, that’s what they spend.
Buyers then use that dollar amount to go buy as much as they can. It’s not based on some inherent value in real estate, it’s based on buying the nicest home you can afford with the money you’ve been allocated.
The effect of this is creating a value in housing based on the available (max allowable) income of the people living in that market area rather than any true value in a property itself. So as interest rates have dropped and remained low, housing prices have risen to accommodate and absorb that increase in capital.
Unfortunately, because the vast majority of homebuyers are buying at their absolute maximum loan to value levels with FHA or low down payment conventional financing, there is very little room for prices to retract without distress in the marketplace.
So unless incomes continue to rise, housing values will be unable to appreciate significantly because they are generally at the maximum of the available income for that particular area. Further, there is very little room for declines in income, which would lead to dropping prices. Of even greater concern is if interest rates should rise, which is generally believed to be inevitable, affordability begins to collapse dramatically.
It is true the short-term effect of these historic low rates seems to have fueled affordability and improved the ability to buy far more home than we could have with higher interest rates. However, the longer-term effect is simply driving housing prices (once again) to that edge of affordability where either declines in an income relative to inflation (i.e. slow wage growth) or increases in interest rates (i.e. returning to normal) will have long-term negative consequences on the housing market and home ownership in America.
So what is the long-term effect going to be? Like a forest that has burned, it can and will be restored in time, but there needs to be time to heal. For now, I expect uncertainty in housing markets and values. While time (and inflation) will always make real estate a safe bet, short-term purchases and excessive upgrading will likely be less financially prudent.
Forget the dream home, think dream life.