How Fed Policy Distorts Home Prices

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I’ve about had it with how giddy a large portion of the U.S. population has become about rising home prices.

Don’t get me wrong, when first thinking about this, I was about as happy as anyone else to learn that property values are now rising sharply again since, after renting for six years, my wife and I finally bought a house about two years ago. So, we stand to benefit as much as anyone else.

But, when you look at what’s driving home prices higher and how unnatural and unsustainable those factors are, suddenly the headlines sound more ominous than optimistic.

Corelogic Home PricesThe glee of Diane Sawyer and David Muir was nearly uncontrollable on ABC News last night as they detailed the latest findings from Corelogic showing that home prices rose by over 6 percent from a year ago.

This video is the closest that I could find at ABC News, but you get the idea.

This LA Times report detailed the findings of a UCLA Anderson Forecast study that indicated the “housing market is becoming the leading source of strength for the long-sluggish American economic recovery“.

On the surface, this sounds like a good thing, but not when you examine what’s driving home prices.

Yes, low inventory is a big factor behind the home price surge as the flood of foreclosures has slowed to a trickle while strong investor demand and growing confidence amongst American consumers have surely tipped the scales in favor of higher prices. But, it is today’s freakishly low interest rates – engineered by the Federal Reserve – that have clearly played the biggest role in pushing home prices higher, simply because most people buy a house based on the monthly mortgage payment, not the purchase price.

And when you see the impact record low rates have on purchase prices, you might be as concerned as I am.

I never thought I’d see the day when you could get a 30-year fixed rate loan at just 3.31 percent, but that was the case last week according to Freddie Mac’s weekly survey of mortgage lenders. While most people probably just shake their head at these astonishingly low numbers, it is homebuyers who are seeing the kind of impact they have on monthly mortgage payments and, as shown below, this effect is profound.

Based on a constant mortgage payment of $1,100 per month (what seemed to be a good national average based on this story and others like it), today’s 3.31 percent 30-year mortgage rate will finance a house at almost double the price that the 40-year average mortgage rate would!

How Much House an $1,100 Mortgage Buys

While there are clearly other factors involved, it is the Federal Reserve’s asset purchase program that is largely responsible for these freakishly low rates (it is one of their stated policy objectives) and, while the central bank has promised to keep rates low for a long time and to continue buying mortgage-backed securities indefinitely, those actions are by no means guaranteed.

As shown above, even if mortgage rates moved back up to their 20-year average rate of 6.5 percent (what many thought were simply unbelievable rates when they first dropped that low last decade), that same $1,100 mortgage payment would finance a home purchase of just $193,000, not the current $279,000.

The difference between these two prices is nearly 50 percent!

Go ahead and plug these numbers into any mortgage calculator and you’ll be as stunned as I was.

As shown below, we’ve really entered uncharted territory this year. During and after World War II, 30-year mortgage rates dipped below five percent for about a decade, but it’s been over a year now since we’ve read headlines like Mortgage rates now below even lows of early 1950s. If you go back a little further to peruse charts like these, you’ll find that mortgage rates didn’t come anywhere close to today’s 3.31 percent.

Mortgage Rates Since 1972

This wouldn’t be nearly as bad if not for the fact that, the lower rates go, the more extreme the impact is on home purchase prices, something that you don’t really realize until you do these calculations. Should 30-year mortgage rates drop to 2.5 percent – something that, somehow, seems quite possible in the year ahead – that same $1,100 mortgage payment will finance a home purchase of about $310,000 and, at 1.5 percent, it works out to be over $350,000!

This is starting to sound a lot like those 2005-era stories of people with $50,000 incomes buying $500,000 houses. How you end up there is much different (liar loans and no-interest loans versus super-low mortgage rates), but the underlying instability that this sort of financing creates is not all that different.

Source: Iacono Research

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About Tim Iacono