The recovery in housing has been very important to the recovery of the economy at large. As such, we keep a very close watch on the state of the housing market. We track a wide variety of metrics related to housing, but perhaps the most important is the Housing Affordability Index (HAI). Produced by the National Association of Realtors (NAR), the HAI uses three variables to arrive at an index value that can be used to track the overall affordability of housing across the US. The three variables are 1) the national median price of an existing single-family home as calculated by NAR; 2) the median family income as reported by the U.S. Bureau of the Census; and 3) the effective rate on loans closed on existing homes from the Federal Housing Finance Board (FHFB).
We decided to make an attempt at forecasting the HAI over the next couple of years. As a first step, we gathered all the historical input data that is used to produce the HAI. As a substitute for the FHFB mortgage rates, we used rates published by Freddie Mac. As you can see in the chart below, the substitution did not create too much of a problem as the index values we calculated (the orange line) track very closely to the actual HAI values (the blue line) over the past ten years. You will also see that after peaking in 2012 at a level of about 207, the HAI dropped to 163.8 in the 3Q16 (which is the most recent data point). This 20%+ drop in affordability was due to a sharp rise in housing prices since the crisis lows, which was partially offset by a solid increase in median family income over that time frame. However, it is the third variable, interest rates, that we want to address.
Mortgage rates had yet to start increasing in earnest until the fourth quarter. Therefore, interest rates had very little impact on the drop in affordability from 2012 until the third quarter of 2016. According to the Freddie Mac data we used, that average rate for the 30-year fixed-rate mortgage was about 3.44% in the third quarter compared to about 4.2% today. So given the sharp spike in interest rates (and therefore mortgage rates) since the election, we thought it would be interesting to see what effect higher mortgage rates will have on housing affordability going forward. We used the following assumptions:
- Median family income increased 4% in 2016 (data not yet released), and will increase by 4% in both 2017 and 2018; this compares to a 2.3% average annual growth rate over the 10 years through 2015
- The average 30-year fixed mortgage rate gradually increases to 5.0% by the end of 2017 and to 5.5% by the end of 2018 compared to about 4.2% today
- The median sales price for existing home sales rises 3% in both 2017 and 2018, which would represent the weakest increases since early 2012
*Source: Data taken from National Association of Realtors; US Census Bureau; Freddie Mac; and Farr, Miller & Washington estimates.
Using assumptions that seem conservative, our model produced an HAI value of 121.3 by the fourth quarter of 2018. This would represent a 26% drop from the most recent reading of 163.8 for the 3Q16 and a whopping 41% drop from the peak in 2012! Moreover, a drop of this magnitude would take us all the way back to affordability levels we last saw in 2007, prior to the big drop in housing prices resulting from the financial crisis. Even if we get more conservative and assume no increase in housing prices over the next two years, the HAI still falls to about 131.5 – a level last seen in 2008 – due entirely to higher mortgage rates!
The point we are trying to make is that in a low interest-rate environment, seemingly minor increases in interest rates (like 100-200 basis points) can have a very big impact on influential sectors of the economy, particularly housing. Those who argue that “interest rates are still low compared to the historical average” are missing the point. Thanks to the Fed’s suppression of interest rates to near zero for eight years, the economy, including most asset prices, has reset to very low levels of interest rates. It doesn’t matter what the level of interest rates was 10 or 20 or 30 years ago. All that matters is that rates have been held to artificially low levels for EIGHT years. So when your real estate agent tells you “it’s never been a better time to buy because interest rates are historically low”, please remember that rising interest rates affect the affordability of your house, and reduced affordability can reduce the value of your home to a prospective buyer.