Welcome to a new Mueller Report after several months of hiatus.
I sent my most recent newsletter in July. Much has happened since then from travel to the busiest season at The Abbey yet. I will likely share more in a future newsletter. Today I want to share an early (i. e. rough) draft of a piece I am working on regarding falling housing prices. I hope a revised version will make it into a publication. If you have ideas or feedback on what I say here, please send it my way!
I’ve decided I really need to commit to writing regularly again. It’s too easy to let other matters crowd out time writing - yet writing is both a large part of my profession, my craft, and an important method of thinking.
So, besides this piece on housing prices, I also plan on writing an essay on the spiritual, philosophical, and practical dimensions of personal debt for the Acton Institute. I may also write a short piece with simply supply and demand analysis of the Inflation Reduction Act’s likely effects on the electric vehicle market. If all goes well, you’ll get to see a draft of one of those next week!
Why Housing Prices Will Fall
It’s been a tough year financially for Americans. No one (except maybe the President) can ignore higher prices everywhere you turn: at the grocery store, at the gas station, and online. While inflation busily erodes the value of our money through rising prices, there are a few prices in the economy that have been moving the other direction: stock prices.
This is not news, but the stock market has declined over 20% since the beginning of the year. That translates into trillions of dollars disappearing from people’s stock portfolios, retirement accounts, and pension funds. Wealth is evaporating at an alarming rate while prices of almost everything else continue to rise.
There is one other major asset class that policy analysts have begun to worry about: real estate.
The early signs of declines in the housing market are already here to see. The cost of borrowing has risen dramatically as the Federal Reserve continues to increase their interest rate target in an attempt to contain inflation. A year ago, you could have taken out a 30-year fixed rate mortgage at 3%. This past week the 30-year fixed rate hit 6.7%. Not coincidentally, the Fed’s target interest rate (3.08%) is 3% higher than it was a year ago (0.06%)…
The median house sold in the U. S. this summer sold for about $440k. Consider what higher interest rates mean for the cost and ability of potential home buyers of the median house.
20% down payment - $88,000
Closing costs - $12,000
30-year fixed rate mortgage - $352,000
Taxes & Insurance - ~$500/month
At 3% - Initial Principal ($604.05) & Interest ($880) = $1,484.05
At 6.3% - Initial Principal ($330.78) & Interest ($1848) = $2,178.78
So we have two different monthly payments. At 3%, the new home owner will be paying roughly $1984.05/month. At 6.3%, the new homeowner will be paying roughly $2678.78/month.
Lenders generally don’t offer people mortgages with monthly payments that will exceed 40% of their monthly gross income.
So what’s the minimum annual salary someone would need qualify for a mortgage for a median house at 3%? $59,500 annually.
But what’s the minimum annual salary someone would need to qualify for a mortgage at the higher interest rate of 6.3%? $80,363 annually.
Roughly 40% of American workers could qualify at an annual salary of $59,500. Only about 25% of American workers can qualify at $80,363.
With about 165 million people in the U. S. work force, we have moved in the past year from a world where hypothetically about 66 million people could qualify for a mortgage to buy the median house to a world where 41.25 million people could qualify.
That means, using rough back of the envelope calculations, there are 25 million fewer potential buyers for the median house…
Housing prices are going to come down.
But should we be concerned?
Why Falling Housing Prices Are….Good?
Henry Hazlitt, author of Economics in One Lesson, argued that the main lesson of economics was to consider the unseen effects and consequences of human action, not simply what is right in front of us. That means weighing the immediate and the long-run effects of public policy or market phenomenon. It also means looking at the effects on all groups in society and not just a few cherry-picked ones.
There are too many effects to consider here, but I want to highlight several effects that are likely to be underreported or neglected altogether. Plenty of people are writing about the loss of wealth (on paper) that a declining housing market will cause. With about 83 million owner-occupied houses, every $10,000 decline in average home prices means a decline of 830,000,000,000 – nearly a trillion dollars. For perspective, homeowner equity declined about $6 trillion dollars in the last housing crash from 2006-2012.
People with adjustable-rate mortgages are going to find themselves in a tough spot once their higher interest rates kick in – which is similar to what happened in 2005 and 2006 as the Federal Reserve raised its target interest rate from roughly 1% to 5.5%. That is an absolute increase of 4.5% and a relative increase of 550%. Compare that to where we are now – an absolute increase of 3% and a relative increase of 5000%.
For the sake of nuance, here is a bit more information. 1st, the 30 fixed mortgage rate did not go up by much from 2005 – 2008, maybe 1% or so. However, the 1-year adjustable rate mortgage rose from a trough of 3.5% in 2004 to nearly 6% in 2006 and 2007. Furthermore, the other major problem many holders of adjustable-rate mortgages faced was that they had low teaser interest rates for the first two years of the mortgage, keeping their monthly mortgage payments artificially low (allowing them to qualify for larger mortgages). They would often refinance at the end of the low-interest teaser period, but as housing prices plateaued and began declining, banks refused to refinance. So these borrowers were caught with their teaser rates ending and increases in the interest rate their mortgages were supposed to adjust to.
Anyone who owns a house will see their net worth decline on paper. That means some people won’t be able to refinance and convert some of their equity to cash. It also means folks who made small down payments will find themselves underwater, owing more money than their house is worth. But for most people, falling house prices has relatively little effect on their daily financial situation.
On the other hand, falling prices are a boon to homebuyers and to society as a whole in the long-run. Buying a house doesn’t feel cheaper in our current environment because the cost of borrow has risen but most home prices have not fallen much yet. But even when they do fall, the houses still won’t feel more affordable because people will still be making similar monthly payments with smaller mortgages.
Recall the earlier example of different borrowing costs. People making $59,500 will qualify for mortgages up to $240,000 instead of up to $352,000. Working backwards with a 20% down payment, it means they can afford a house costing up to: $300,000; a whopping $140,000 less than the current median house price.
I am looking at edge cases here, and it would be more than a little simplistic to claim that the median house price will move down to $300,000 (that would entail a $14 trillion decline in homeowners’ equity, or about a 50% decline. Interestingly, that remarkable evaporation of equity would still leave us with a similar amount of equity to what households had at the peak of the previous housing bubble in 2006…)
With this admittedly extreme and unrealistic case of the median home price being $300,000, what effects are worth noting?
As I’ve noted, the monthly costs of a mortgage are basically the same as in the case of the median home price being $440,000 with interest rates at 3%.
But people will be less indebted in the second situation – meaning they need less money ($152,000) to payoff their the principal of their mortgage for the cheaper house.
A higher interest rate also means a higher return for making extra principal payments. You’re effectively “earning” 6.3% annually on any principal payments for the duration of the loan.
Third, you do not need as large of a down payment. Instead of $88,000 plus $12,000 in closing costs ($100,000) to buy the median house, you now need $60,000 plus $12,000 ($72,000) in cash to buy the cheaper house.
Falling house prices are also likely to change the relative profitability of high-end luxury housing and smaller more affordable housing in favor of the latter because rising interest rates magnify the cost of leverage so much in absolute terms. Consider the principal and interest payment change from 3% to 6.3% for a $100,000 ($421.60 to $618.97), $500,000 ($2108.02 to 3094.86), and $1,000,000 ($4216.04 to $6189.73)
You need $5,900 more income per year to qualify for the $100,000 mortgage at 6.3%
You need $29,640 more income per year to qualify for the $500,000 mortgage at 6.3%
You need $59,000 more income per year to qualify for the $1,000,000 mortgage at 6.3%
We’ve been hearing about “unaffordable” housing for years - would it be such a bad thing for it to become affordable again?
Hope to send you something else next week!
Good Report and enjoyed the topic.
A few quick observations and comments.
I understand the "Why Falling Housing Prices Are…. Good?" statement. Discussing how supply and demand often reach an equilibrium of sorts based upon striking a 'value' position for the resource in question may be useful.
I suggest you expand the inflation thread. The increased expenditures due to inflation on other household needs such as food, gas, entertainment, services, education, etc. are going to have a direct impact on available mortgage funds.
My experience is Lenders generally require mortgages to be less than 1/3 or 33% of their monthly gross income. I don't recall any personal examples of people (or Lenders) telling me they allowed 40%.
You may want to add another category between a $100k mortgage and $500k mortgage since most people don't qualify or can relate to $500k and $1,000k mortgages.
Shalom.
-- Duane