Housing Market Affordability Has Crossed a Concerning Threshold in the U.S.

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In just the last couple of weeks alone, mortgage rates have shot up from about 3.1% to over 3.5%—the highest they have been in over 22 months. 

The fact that mortgage rates are starting to rise should come as no surprise. After all, the Fed recently signaled that it would raise rates between two to four times in 2022. And, bond yields and mortgage rates are likely to follow suit.

What is surprising, though, is how quickly rates have risen. It appears that the market is starting to price in future rate hikes well before they happen. And, as a result, housing affordability—which I believe is one of the two most important indicators to watch in 2022—is taking a big hit. 

How housing market affordability is affecting homebuyers

Housing market affordability is a metric that measures the ability of an average homebuyer to afford an average home in the U.S. This metric can be measured a few different ways, but there are generally three primary components: 

1. Median home price
2. Interest rates
3. Median income 

Median income and interest rates are important metrics when measuring affordability because they help to gauge how much a homebuyer will pay for the median house, presuming that they are using at least some type of financing for their purchase. And, because financing involves paying interest on the money you borrow, when interest rates and home prices go up, affordability goes down. 

To fully understand affordability, you also need to take into account the median income in the U.S., as that determines whether homebuyers can reasonably afford the true price of a home purchase. When income goes up, affordability improves. 

Right now, all three components are rising. We all know the median home price is up more than 15% compared to last year, which means that homes are less affordable.

And, as I mentioned at the beginning of this article, interest rates rose 45 basis points in the last few weeks. Luckily, wages in the U.S. are also rising, but not enough to counteract the impact of rising home prices and interest rates. 

One of the major ways affordability is measured is through the National Association of Realtors First-Time Affordability Index. And, just last week, that index dropped below 100, which means it dipped below a significant threshold.

“This means that first-time homebuyers with the median income don’t have enough income to qualify for a mortgage on a median-priced starter home. Specifically, the median family income of renters in the 25-44-year-old age group is about $57,000, while the qualifying income for a starter home is $62,000,” said Nadia Evangelou, NAR’s Senior Economist and Director of Forecasting, 

This is what I mean when I say that the housing market is entering precarious territory when it comes to affordability. Because rates have risen in the last few weeks, the average first-time home buyer can no longer qualify for the loan needed to purchase a median-priced home.

What does this new data mean for the housing market overall?

I don’t want to be an alarmist here because I do not think a crash is imminent. That said, I believe this data represents an important shift in the dynamics of the housing market. As affordability declines, it is likely that demand is going to suffer.

And, when demand drops, the prices can, too. To be clear, though, that’s not necessarily going to happen. Things in this housing market are not that straightforward. 

There are a few other factors to consider here. For starters, this analysis is just for first-time homebuyers and for median-priced homes. This doesn’t account for investor activity, repeat buyers, or second-home buyers.

And, demand has actually gone up in recent weeks. According to the Mortgage Bankers Association, people are applying for more purchase mortgages right now than even a few weeks prior. This makes sense, as homebuyers are looking to lock in rates before they increase even more.

That said, it’s unclear how long the fear of rising rates will actually bolster demand, or what the rates will be when they hit a point where demand falls. But as we all know, inventory is severely constrained in this housing market, so it could take a big drop in demand before prices growth slows, or starts to fall. 

To me, what happens next is a question of how fast rates rise and what happens with the housing inventory. If rates rise quickly, it will cool the housing market significantly. And, it could even send prices sliding backward—particularly if inventory levels start to climb. 

If rates rise slowly, the market will likely adjust to the rising rates. As such, home prices could keep trending upward, albeit at what is likely a slower pace. 

Other questions to consider in the current housing market

The biggest question I have is this: What exactly is the mortgage market pricing in right now? Is the market assuming three Fed rate hikes this year and thus pricing current day mortgages accordingly? Or will we see mortgage rates spike each time the Fed actually makes a hike—which would be on top of the recent increases? 

While this is just my opinion, I don’t think the dynamics of the housing market will change too much in the coming months. Demand is still strong, supply is still incredibly low, and prices will likely keep going up. But this analysis by NAR could be a lead indicator of dropping demand in the not-so-distant future.

Ultimately, what happens in the second half of 2022 is more of a question market for me. My estimate right now is that a cooling will drop year-over-year appreciation to 2% to 7% appreciation rates by year-end.

That said, I’m still looking to buy.

Final thoughts on the current housing market affordability trends

Yes, interest rates are increasing—and yes, we’re no longer seeing record lows. This will put downward pressure on housing prices. But even at 3.5%, mortgage rates are still incredibly low in a historical context.

And despite rising rates and a lot of economic uncertainty, the one thing I have supreme confidence in is that I will be very happy with a 3.5% interest rate in 10, 20, or even 30 years. 

This, of course, is just my reading of the data and the economic climate as it stands today. Things are changing rapidly, and I will be continually updating my outlook in the coming months. As I do so, I will be sure to share my thoughts with all of you—especially as we get more economic data to help guide investing decisions. 

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.