The Honest History of Home Prices and Mortgage Rates

30 year mortgage rates have absolutely skyrocketed this year. Mortgage News Daily’s index tracking 30 year mortgage rates hit 4.95% on Friday, March 25th, up nearly a full percentage point since the start of the month. Affordability is cratering for first time buyers, as each 1% increase in mortgage rates causes a 12.5% increase in the monthly principal and interest payment on a 30 year note.

iBuyers, real estate agents, and individual home owners obsessed with their fake Zestimate^TM are out in full damage control mode, trying to shape the narrative. “Why The Housing Market Won’t Crash Any Time Soon,” “No, The Housing Market Isn’t In A Bubble,” and “Is It True That High Interest Rates Will Cause Housing Prices to Drop?” are just a few of the intellectually dishonest articles and blog posts that I’ve read recently, on top of forecasts that home prices will rise an additional 15–20% or so this year even in the face of rising interest rates. Many of these articles seem convincing on the surface because they cite historical data. However economics is rife with multivariable systems, and in these cases proper identification and presentation of all variables is key to creating proper context.

Let’s set aside for a second the foolishness of trying to find historical precedent in a market that has no precedent; wherein The Federal Reserve purchased nearly $1.5 trillion in Mortgage Backed Securities (MBS) over the past two years; wherein poorly targeted fiscal stimulus programs put more spending money than ever in the pockets of average Americans; wherein a global pandemic accelerated many Americans’ plan to buy a home while causing others to delay plans to move.

Usually the data in these articles that I am complaining about is presented something like this (click to enlarge):

The narrative presented is that mortgage interest rates skyrocketed to over 16% during the course of stagflation in the 1970’s, and home prices continued to rise over this period. Therefore there is no historical precedent for rising interest rates leading to a fall in nominal home prices, and the same situation will occur today.

If the housing market were a single variable system, then this conclusion may be accurate. However to even attempt to present the housing market as such a simple model is misleading. There are so many variables here that PhDs in economics and data science rightfully spend entire careers attempting to develop the most accurate predictive models.

Proper analysis for our purposes in this article will simply attempt to define additional important variables which are convincing enough to disprove the common wisdom and the prevalent narrative, and present an explanation for why the economic theory of an inverse relationship between asset prices and interest rates was not observed in the 1970’s.

“Buying the Monthly Payment,” a practical model based on the median American home buyer’s approach

Cash offers tend to float around 20–30% as a share of total home purchases. The percentage of these that are “real” cash offers is up for debate, as many cash buyers end up using delayed financing or doing a refinance immediately after purchasing. Additionally there is a crop of companies popping up (whom I will give no free advertising to) which put in a cash offer on the buyer’s behalf for a fee of 2–3% of the purchase price of the home, then the buyer gets a loan and buys the home back from them. This is an aside and the important takeaway here should not be controversial, which is that the vast majority of American home buyers need to take out a mortgage to finance their purchase.

How do people determine the price range for homes that they can purchase? The more financially literate ones set a budget for their desired monthly mortgage payment as a percentage of their income, and note what home price range they can shop in based on their down payment and prevailing mortgage rates. The less financially literate ones simply shop in the home price range that their mortgage lender pre-approves them for, however the variables are the same, just in this case the buyer is effectively letting their lender set their debt-to-income ratio. Which does not change that the three constraints in this equation are still their household income, down payment, and prevailing mortgage rates.

Let’s take a look at average down payments over time:

As we can see average down payments have maintained a pretty tight range and low volatility from year to year. This will not have a significant effect on monthly payments over time. For simplicity we can remove the down payment from consideration in our “buying the monthly payment” model and instead focus on interest rates and median household income, which will be by far the dominant factors affecting the home price a buyer can afford.

The honest history of home prices and mortgage rates, in one chart

We’ve now got three data sets over time to contend with, but we can actually reduce that to two data sets and make our graph easier to interpret by creating a ratio between the median annual home price and the median annual household income. The result is not a pretty chart at first glance, but with a bit of study is really quite enlightening (click to enlarge):

First off, using this chart we can quite easily disprove that the rising rate scenario in the 1970’s is at all analogous to today. That decade started where a median household could purchase the median home for under 3x their household income. This ratio grew to around 4x the median household income over the 1970’s, and hovered around that multiple as mortgage rates were in the double digit percentages between 1979 and 1990.

Today of course, we see the median home sells for nearly 6x the median household income! For the 1970’s stagflation environment to be a good precedent for today, the median home today would have to sell for around $200k USD, rather than the current median price of just over $400k. As a thought exercise, let’s imagine this was true today.

We take our fictitious $200k home, put 10% down, pay 1.28% in property taxes (just the figure in my local area), and add on a little for home insurance and PMI. At a 3.5% mortgage rate, the monthly payment on this fictitious home of 3x the median income would be about $1,080. That’s nothing, chump change. Imagine if you could buy a home for that payment?

Now we take the interest rate dial and crank it… how far do we need to go to double the monthly payment of this theoretical home? To get a payment of $2,160 per month, we needed to go all the way to a 12.25% mortgage rate! A $2,160 payment is nothing crazy by today’s standards, and is in fact very closely in line with the payment today’s buyers would end up with based on the median asking price, according to Redfin:

Today’s housing market is not the 1970s all over again

The simple conclusion as evidenced by the data I have presented, is that home prices did not fall (and in fact rose) in nominal terms as interest rates rose in the 1970’s because the median home was so cheap in relative terms to the median household’s income that buyers had ample extra financial cushion to absorb all of these rate increases, as well as absorb the median home price climbing from 3x to 4x of the median household income.

The “worst case scenario” was for 1981 home buyers, where a median earning family would have paid 3.9x their income for the median house, but at a staggering 16.5% mortgage rate, roughly tripling the total monthly cost to own a home compared to a decade earlier. Of course, with the benefit of hindsight we can state that anybody who did purchase at those levels was not financially stressed for long as they were quickly able to refinance their way into a smaller payment over and over again in the ensuing years.

Affordability metrics as calculated by the total monthly payment based on the median home price to median income ratio and the prevailing 30 year mortgage rate at the time, means that if today is analogous to any time in the 1970’s, it is somewhere between 1978 and 1979.

And, well, just take a look at what happened to real home prices starting in 1979:

Honestly, the bullish position for housing should be arguing as their best case scenario that nominal prices stay flat while rates rise. Don’t get me wrong, there’s still potential room for monthly mortgage payments to grow before we eclipse the historical worst case scenarios. But unless real incomes grow substantially, at present housing price to income ratios, we seem to be within a stone’s toss of the mortgage rates that would be required to meet that threshold.

It’s pure hubris and greed from these recent home buyers who think now that they’ve locked in their 3% interest rate, their home equity is going to continue to rocket up and away in this environment. Many of these people would gleefully pull the ladder up behind them and lock future generations out of home ownership if only for their own self-enrichment if they were given the option.

That’s a whole lot of words to essentially say, don’t take economic postulating seriously from anybody (even myself), but especially not someone who thinks they can boil the housing market down to a single variable model based on something like historical interest rates.

Where do we go from here?

As I’ve already alluded to, this market has no precedent. This time is well and truly different as it is every time, because history does not repeat but it does rhyme.

Obviously if you can buy today within your financial comfort level, then go for it. I’m not quite sure how many people are left that can comfortably buy at today’s prices with mortgage rates kissing 5%, but there’s bound to be a few.

Personally I find it incredibly difficult to justify pulling the trigger on someone’s poorly maintained dumpster of a home last updated in 1980 — which needs a ton of sweat equity and money in updates and fixes poured into it — for over $3,000 per month in my local area when I can rent a “luxury apartment” for $2,200 per month. Could I afford the total cost of ownership, sure. We’re the furthest thing from priced out as far as lenders are concerned. Is it financially wise? That’s the question I ask myself with every home showing, and probably why we’ve only found seven homes we even cared to offer on in the past two years.

It’s important to note the lagging nature of home sale data. The closed sales you see today, likely went under contract 1.5–2 months ago when mortgage rates were in the 3.7–4% range. On a constant monthly payment basis, these sales are not comps in a 5% rate environment unless you discount the selling price by 10% or more.

As I visited yet another packed open house today I wondered how quickly information diffuses through buyers. How many potential buyers there today were still under the impression they would be getting a 3.x% interest rate if they went through with the purchase? Lower information buyers would certainly be more willing to overbid on a property, and therefore this iteration of the pandemic real estate market may be the strangest yet. Once you’ve won the bid you either stretch financially to make the loan work at prevailing interest rates or you sacrifice your earnest money deposit. I suspect we will see an increase in “Back on Market” properties in the coming weeks as some of these sales fall through.

Furthermore I speculate that inventory will slowly build over April and May due to reduced affordability as mortgage rates continue to climb higher. Inventory is really the key to this whole equation, regardless of whether it is acquired through increased supply, reduced demand, or some combination of both. Once nearly every home that hits the market isn’t selling in under a week, buyer sentiment will cool further and bidding wars will disappear within weeks, as quickly as they appeared at the start of the pandemic. The rush to “buy before you are priced out forever” will abate once people see options of homes sitting on the market untouched that they could purchase for the list price if they cared to. A shift to a more balanced market between buyers and sellers will be a boon for financially conscious buyers who are not willing to waive every contingency to win a bid on a home.

I think it’s likely that Federal Reserve tightening actions would cause a housing market price correction in a vacuum, as they continue to raise their target rates as well as make decisions as soon as May on allowing Mortgage Backed Securities (MBS) and Treasuries to begin to roll off their balance sheet. Housing prices decreasing commensurately with increases in mortgage rates to maintain relatively constant monthly payments is my bet. What happens in the broader economy and whether we slide into a recession in the near future will determine whether this will be a “healthy correction” versus another housing crisis, as the Fed may end up with their hands tied in terms of policy response in the face of still-raging inflation.

The good news is that regardless of what happens with the housing market, those who make a conscious effort to live far below their means, save, and build liquid assets will come out better than fine in the long run. If your income tracks with nominal wage gains, and you are building wealth more quickly than the vast majority of people in your local area, it does not make logical sense that you can be permanently priced out of your local housing market.

Good luck out there if you’re shopping for a home in this market — keep your ear to the ground on activity levels and closing prices in your local area, keep saving, and remain ready to pull the trigger once you’ve found the right home and the rent versus buying calculation comes out to an acceptable number for your personal situation.

Update: Check out my follow-up article on Fall 2022 housing affordability and the state of the market.