Unfortunately, as long as US homes are largely purchased with 30-year mortgages, we are going to see large price swings for houses as interest rates swing, and bail-outs are likely every time interest rates go up unless it goes up very slowly and inflation goes up to match. This is a structural problem that is going to be difficult to avoid, since many institutions are dependent on this system including millions of voters. At least understanding how this happens can help motivate looking for alternative systems, such as debt-free housing.
The structural problem stems from people buying as much house as they can afford, and how much house they can afford is based on the monthly payment. (http://www.bis.org/publ/qtrpdf/r_qt0403f.pdf) I do not believe this is because people are greedy, but rather that competitive pressures cause the housing prices to rise to meet the market. That is to say, if the majority of people were not willing to pay a particular amount, then the housing prices would change to reflect this. This would not change the housing stock, it would just change the price it would sell for. The above cited study shows that people are willing to pay what is determined by the percentage of income allowed by government mortgage guarantee programs (Fannie Mae and Freddie Mac).
“The 30-year loan first became broadly available by an act of Congress in 1954 and, from then until now, the vast majority of such loans have been issued only with government support.” https://www.nytimes.com/2011/03/04/business/04housing.html?pagewanted=2&_r=1&partner=rss&emc=rss
If this government support program were to disappear, then housing prices would fall since banks are unlikely to give more favorable terms, or they would be giving them already. Since so many people and institutions would suffer with a general fall in housing prices, it will be politically difficult to take away this program.
The next step is that given a monthly mortgage rate, the price of the house is a straight calculation based on the interest rate—for a given monthly payment, the lower the interest rate, the higher the price. Monthly payments are based on salaries, since there is a formula that the federal mortgage guarantee entities use to calculate this. (http://www.census.gov/hhes/www/housing/special-topics/files/who-can-afford.pdf)
The price is largely set by the monthly mortgage that people in the area can afford, rather than the worth of the house. In the 70?s and 80?s in the United States the mortgage payments were set at a maximum of 28-29% of income to be guaranteed by the government. These regulations were loosened during the 2000’s which helped create the housing bubble thus the bail-outs and foreclosure boom that is going on now. But interest rates are at historic lows, with government guaranteed 30-year fixed mortgages at less than 5% interest. When this interest rate raises, then either housing prices will fall or monthly payments will have to rise. Monthly payments are based on salaries, which in turn are changed based on inflation. Housing prices falling will cause more foreclosures because more houses will have an outstanding mortgage for more than they are worth, and mortgage holders will not be able to move out of a house based on selling it, so will have to foreclose if they want to move or can not afford the monthly payment for some reason.
Will inflation raise salaries enough to compensate for a raise in interest rates? It does not appear so, unless interest rates rise very slowly. A $250,000 dollar loan at 4% interest costs $1200 per month, yet if the interest rate went up to 10%, then the cost would be over $2,100 per month. The salary would have to double to afford this increase. Doubling based on 7% inflation would take 9 years (see below). So as interest rates increase, inflating salaries will likely lag, thus causing a downward pressure on housing prices.
With 30-year mortgages, the fluctuations in interest rates will likely cause housing prices to fluctuate more than inflation can even out. Housing price decreases cause foreclosures, and enough foreclosures cause bank failures or bail-outs. Debt-free housing avoids this, but that is the subject of other posts.
|Option 1||Option 2|
|min yearly salary||$49,388||$90,783|
|years to inflate salary||7%||$90,797|