Most analysts focus on job growth or wage growth as the fundamental that underpins the housing market. While job growth is extremely important to homebuilders who provide supply for the newly employed, job growth isn’t what establishes market pricing.
Financing terms largely determine the equilibrium price for housing. Short term fluctuations in supply and demand cause gyrations, but over time buyers lift house prices to the limit of what they can borrow.
For example, house prices recovered so quickly after the 2012 bottom because buyers could borrow peak prices due to very low interest rates. The depleted MLS inventory forced buyers to compete, but it was their increased borrowing power that really caused prices to rise. Prices rose until buyers reached the limits of their borrowing power, which is where we are today.
House prices rely on four things:
- Interest Rates
- Borrower Income
- Allowable-Debt-to-Income Ratios
The impact of interest rates is obvious. The lower they are, the more someone can borrow, and the higher they are, the less someone can borrow. Mortgage balances are inversely related to mortgage interest rates.
Lenders explored temporary “teaser” rates during the early 2000’s because the lower rate allowed them to underwrite much larger loans, enabling borrowers to become buyers in large numbers. Everyone hoped they could refinance before the rate reset higher and the payment recast to something the borrower could not afford. Unfortunately, it didn’t work out. Qualifying based on teaser rates was banned by Dodd-Frank.
Borrower Income and Debt-to-Income Ratios
Borrower income and the allowable debt-to-income ratios work together to determine how much payment a borrower can afford. This assumes the borrower actually makes the amount stated on the loan application, and during the last bubble, this was often not verified. In order to calculate the maximum loan value someone could borrow, the lender needs an interest rate, borrower income, and the maximum DTI the bank will allow. For example, a borrower making $100,000 qualifying at a 31% allowable DTI can afford a $31,000 annual housing bill (includes interest, taxes, insurance, HOAs and other costs). That translates to a $2,583 monthly payment.
This assumes borrowers will max out their loan balances, and that isn’t always the case. Many areas of the country, but most notably in the Midwest, borrowers simply aren’t willing to leverage themselves to the max, and they accept lesser housing quality (and lower prices) as a consequence. In California, nearly everyone borrows the maximum their lender will allow.
The new financial regulations capped back-end DTI ratios at 43% for all residential loans and banned low-doc and no-doc mortgages.
The type of loan program matters. Amortizing loans make for the smallest loan balances because a portion of the payment goes toward paying down principal. If the loan does not amortize, the entire payment can go toward interest, and the loan balance can be about 15% larger. At its ultimate extreme, if the loan negatively amortizes (the balance gets bigger rather than smaller), and lenders use teaser rates, truly prodigious loan balances can be underwritten on very small payments. Buyers on the margins using these methods inflated the Great Housing Bubble.
Many of my cartoons are just for fun, but there is often a serious point behind them. The cartoon about housing market drag racing below illustrates the credit cycle that inflates housing bubbles.
In a “normal” market, prices are determined by the interaction of interest rates, borrower income, and debt-to-income ratios applied to a 30-year fixed-rate amortizing mortgage. In normal markets, the friction that limits the number of transactions is generally affordability. Needing to borrow more money to get their dream homes, desperate borrowers sometimes respond by financing with adjustable-rate mortgages. The first sign of an overheating market is an increase in ARMs.
The same forces that compels people to use ARMs further compels them to abandon amortization altogether. There is a slow but inexorable migration from amortizing ARMs to interest-only ARMs and finally to negatively amortizing loans. Unfortunately, interest-only and negatively amortizing loans are Ponzi loans, and once they proliferate, the market implodes. The inevitable credit crunch prompts lenders to retreat back to stable conventional mortgages. In order to prevent recurrence of this cycle, Dodd-Frank banned both interest-only and negatively amortizing loans.