That is an interesting graph.
I think the two most important factors for home prices are: 1) household income and 2) interest rates / financing terms.
If household income moved up 10% (say from $50K to $55K), I believe home prices would move up 10%, ceteris paribus. This is independent of whether the income increase was real or just due to inflation. I think this is the general trend line for homes.
Interest rates and financing terms are ups and downs on the general trend line. If interest rates dropped, say from 8% to 6%, the initial reaction is that the buyer could afford 33% more. But it is actually a little more complicated. It depends on the financing terms and, to a lesser extent, taxes. My basic argument is that home buyers care more about their monthly payment and less about the price of the home.
As an example: Someone that could afford $2000 per month in total payments (PITI) could get approximately a $230K 30 year loan + $57K down (20%) = $287K home price.
But that same person, with a 6% 30 year mortgage, could afford a $284K loan + $57K down (same amount as above) = $341K. With those assumptions, home prices would increase by about 20%. (All numbers are approximate depending on taxes and insurance).
Of course, if interest rates increased back to 8%, home prices would fall under this model. In reality, they fall very little or fall gradually because housing is an “imperfect market”. (That would be another post).
Another factor is the financing terms. This would include down payment requirements, durations, ARMs, and other creative financing. The lower the down payment, the more people that can afford homes in a certain price range. In that case, we get a little supply / demand surge in homes.
NOTE: I’ve been advocating gradually increasing down payment requirements (as opposed to immediately raising rates) as a way to slow the housing bubble. Right now, lenders are loosening requirements – exactly the opposite of prudent behavior.
"A sound banker, alas, is not one who forsees danger and avoids it, but one who, when he is ruined, is ruined in a conventional and orthodox way along with his fellows, so that no one can really blame him".
- John Maynard Keynes
And a final comment on down payment requirements: No money down loans (or close to 0% down payment) boosts home prices even more. This is because a “moral hazard” occurs, where the home buyer takes on no risk of downside moves in the home price. This leads to rational speculation: buy a home with the expectation it will increase, but walk away if the price declines. We are seeing some of this right now. |
