We’ve all seen recent reports about inflation and certainly felt its effects. It feels good if you’re a homeowner and similar homes around you sell for much higher prices than you paid. You feel wealthier, and you could tap big equity at cheap rates! But if you’re hoping to buy a home, it doesn’t feel so great. Bidding wars create a scary upward spiral for aspiring buyers.
Last spring, they told us general inflation was transitory and blamed the supply chain. Because it’s steadily increasing, the Federal Reserve Bank may continue increasing short-term interest rates three to four more times this year to combat it. Some prognosticators believe they’ll raise rates seven to eight times because, according to the U.S. Bureau of Labor Statistics, inflation measured by the Consumer Price Index is now running at about 7.9 percent year over year. The producer price index is 10 percent year over year, suggesting higher consumer prices may be around the corner.
Increasing short-term interest rates, or the rate the member banks of the federal reserve system charge each other to borrow money, increases costs to consumers because they pass it along. They have to charge their customers more than they pay for money to make a profit. Long-term interest rates, such as home mortgages, are a different story.
Bankers watch the 10-year Treasury note and mortgage-backed securities to set mortgage interest rates competitively. Although the Fed doesn’t control these rates, they manipulate them by buying government bonds and mortgage-backed securities with money invented out of thin air. When they drive up these prices, the interest rates come down. When investors pay more for the same return, the yield is lower.
The Fed inflates the money supply by adding digits to commercial bank accounts. These banks buy government bonds allowing our country to spend much more than we receive in tax receipts. The banks sell these bonds to the Fed for cash as the Fed’s balance sheet grows with the debt we, the American taxpayers, owe. Did you get that? The Fed creates money out of nothing that comes back to them in debt instruments we must pay. They use commercial banks as the middleman. The banks then loan out much more than they keep in their accounts, increasing the money supply with each loan they make.
The money created from thin air flows quickly into the stock market, commodities, and raw materials, driving up producer and consumer prices. Monetary inflation causes general inflation. Wage inflation feeds the spiral, but higher paychecks don’t keep up with rising prices, especially housing costs. It’s all driven by bureaucrats implementing a flawed theory that grows our national debt even more quickly.
What Happens to Home Prices and Affordability?
Bubbles are finance and monetary policy-driven. But real estate professionals know that the affordability index naturally regulates residential real estate prices.
If you take the median family income in an area and use a standard maximum debt to income ratio, you’ll find the highest average housing price incomes will sustain. It’s straightforward. The market reveals what people can afford.
In the following three examples, we’re using the median American family income (according to the Department of Housing and Urban Development) for 2021. It’s similar to the median family income in Ventura, California, where I live. Here, real estate prices are considerably higher than the national average, while family income is about average for the United States. A correction in home prices may start in places like this and then spread to the rest of the country as it did in 2005-2006.
The Fannie Mae computer system will approve up to a 50 percent debt to income ratio for a typical loan, but a 50 percent DTI indicates what a family can barely afford. They won’t be able to do much else in life financially but survive and be a slave to their mortgage payments. People are much more willing to do this when they think prices will continue rising.
Suppose the median annual family income in an area is $79,900 (the national average currently according to HUD), or $6,658 monthly. In that case, the maximum Fannie Mae income from the DTI ratio is $3,329 monthly (50 percent of the gross monthly income).
Let’s allow $300 for a frugal family’s other payments (car loans, student loans, credit card payments, and other included obligations) and $700 for property taxes and insurance on the new home. We have $2,329 remaining for monthly principal and interest payments.
Property tax, insurance, and debt payments will vary, but we’re holding them constant to show the impact of interest rates on affordability.
Now, consider the following three examples and ask yourself if I’m predicting the future.
Although a bit higher now, the prevailing interest rate on a 30-year fixed mortgage was about 2.75 percent over the last year. A maximum approvable principal and interest payment of $2,329 allows a mortgage amount of $570,496.10. If you put 20 percent down, your new home’s sales price is $713,120.13.
When rates normalize (the Fed says it’s stopping their manipulation imminently), the prevailing interest rate on a 30-year fixed mortgage becomes 5 percent. A maximum principal and interest payment of $2,329 then allows a mortgage amount of $433,849.89. If you put 20 percent down, your new home’s sales price is $542,312.36.
Suppose interest rates run higher (not out of the question historically but primarily because of such reckless government deficit spending coming back to bite us). In that case, the prevailing interest rate on a 30-year fixed mortgage goes up to 7.5 percent. A maximum principal and interest payment of $2,329 allows a mortgage amount of $333,088.05. If you put 20 percent down, your new home’s sales price is $416,360.06.
Today, a very modest house squeezed between other small homes on tiny lots in Ventura, California, costs about $713,120. If mortgage rates go to 7.5 percent and incomes don’t go up, that price could drop to $416,360 because that’s the maximum average affordability. We’d get a 41.6 percent drop in home values. How low could prices go with early 1980s interest rates and the panicking fish all darting in the same downward direction?
Even if inflation mitigates the nominal price drop, do you think, in real terms, middle-class incomes will rise proportionally, especially with more restrictive government regulations on businesses and tax hikes? At the federal level, those in power today believe we are not regulated enough, and taxes need to be much higher to achieve “equity.”
We’ll reach equilibrium in real estate by forced digit deletion (the invented money by the Fed) through foreclosures and short sales. When you have a $570,000 loan on a home worth $400,000, and people believe prices will continue dropping, the note holder ends up with perhaps $350,000 after repairs, carrying and marketing costs, and real estate commissions after the foreclosure and resale process.
Who else loses? In the first example, the buyers put down almost $143,000. With closing costs, let’s round up to a $150,000 outlay and say it took them 10 years to save that much. The money represents a decade of work where they produced value for customers, employers, and stockholders and received income in exchange. It’s not only money down the drain; they received it in exchange for a big chunk of their productive lives. That gets deleted too.
Our children also lose, as the manipulation by the Federal Reserve Bank and our politicians to keep interest rates unnaturally low directly caused enormous additional national debt. Even if real estate, stocks, and bonds values implode, taxpayers still owe what remains and at potentially much higher interest rates. Will future generations be able to pay our bill?
If Congress didn’t deficit spend, and our banking system increased the money supply with a growing economy but not more, we’d have a slight deflation. As efficiencies rose with new technologies and better production methods, our increased pay would come to us in real terms, and we’d have a higher standard of living for the average person. Just imagine: Everything becomes more affordable over time as we pay down our national debt with surpluses. Why is good policy too much to ask from our leaders?