Future loan terms determine future home prices

One of my earliest posts in May of 2007 was about the impact future loan terms have on future home prices. Most people just assume house prices always go up. Their faith was shaken by a precipitous decline over the last six years, but once the bottom is securely in the rear-view mirror, kool aid intoxication in faith-based appreciation will undoubtedly return. I want to revisit the idea of future house prices depending on future loan terms because it makes a strong case for weak home price appreciation going forward. The how and why matters, and before kool aid takes hold again, it pays to understand what it would take for house prices to go up from here.

Over the holiday, I reposted a series on cost of ownership. In the post Ownership cost: income, payments and house prices, I lay out the four variables that determine market price:

  1. borrower income,
  2. allowable debt-to-income ratios,
  3. interest rates, and
  4. down payment requirements.

Interest Rates

In another recent post, Orange County monthly cost of ownership falls to 1980s levels, I noted that the cost of ownership is the same today as it was in 1989; therefore, all appreciation over the last 23 years is due to a decline in interest rates from 10.77% in April 1989 to 3.5% in October 2012. Was it reasonable for a buyer in 1989 to assume house prices would rise because interest rates would decline 70%. If so, it is reasonable to assume we will have 1% mortgage interest rates 25 years from now to keep prices rising?

The above example shows the dramatic impact interest rates have on house prices, and unless mortgage interest rates keep making new record lows for the next 25 years, that engine of home price appreciation will run out of gas. When interest rates finally do move higher, the math dictates that loan balances will get smaller. That could negatively impact resale prices.

I covered this issue in detail in Will rising interest rates cause house prices to crash?. The bottom line is this; If interest rates go on a sustained rise, financing home purchases will become more expensive. That is the math. The real question then is whether or not these rising interest rates are compensated for by rising wages. If wages rise as fast as interest rates do, then borrowers will still be able to finance large sums, and house prices can remain stable or even rise. However, if wages do not rise as interest rates go up, then loan balances will decline, and house prices will fall again.

Borrower income

That brings us back to the first of the four variables listed, borrower income. Ordinarily, incomes rise over time as the economy expands and workers can demand higher pay for their services. However, in an era of high unemployment, wages generally do not rise because workers do not have the leverage to demand higher pay. In fact, in many industries, wages actually go down as the supply of workers exceeds the demand for their services and those who wish to remain in the field lower their expectations. All economic indicators point to continued high unemployment for the next several years. The only way the federal reserve can hope to overcome this is to print more money, a policy with its own drawbacks.

Borrower income and the interest rate cycle and inflation all come together to create a set of conditions at the bottom of a credit contraction recession that does not favor rapid house price appreciation. The bottom of the interest rate cycle typically drags on for several years as the federal reserve tries to boost the economy. Sustained low interest rates causes inflation to flare up, and the federal reserve is usually one step behind rising inflation.

Rising interest rates would slow economic activity and hurt home affordability, so the federal reserve will resist doing so for as long as possible. Inflation will ultimately force their hand, but that could be many years into the future. During the 1960s and 1970s each time the federal reserve raised interest rates, it triggered a recession that forced them to lower rates once again. It wasn’t until inflation got completely out of control due to a collapsing dollar that the federal reserve raised rates enough to curb inflation. That caused the double-dip recessions of 1980 and 1982, what is now the second-worst recession since the Great Depression (our recent recession was even worse).

Debt-to-income ratios

The inflation of the 1970s did cause both wages and house prices to go up, but the two didn’t go hand-in-hand. Lenders lost control of one of the other key variables: debt-to-income ratios.


During the 1970s lenders threw out their standards for debt-to-income ratios and underwrote loans at 60% DTIs and higher. So why did they do it? Well, with runaway wage inflation, which we had in the 1970s, what is a 60% DTI this year becomes a 55% DTI next year, and a 50% DTI a year after that and so on until the mortgage payment is manageable after just a few years. This is where the erroneous conventional wisdom about stretching to get a starter home comes from. If you could survive on nothing for a few years, over time the rapid wage inflation would make your house payment small and manageable. Plus, the owner got a boatload of appreciation to boot. Of course, this is a Ponzi scheme because it relies on ever-increasing wage inflation which may not come to pass. And when Paul Volcker tamed inflation in the 1980s, wage inflation did stop, house prices crashed in California, and the Ponzi scheme unraveled.

It’s unlikely lenders will permit DTIs much higher than today’s. The current allowable DTIs are as high as they can possibly be to sustain home ownership. We know this because during the first round of loan modifications in 2008 (which nearly all failed), the DTIs were reduced to 38%. That was far too high. Lenders had to reduce DTIs to 31% before people stopped defaulting. Absent Ponzi borrowing or rapid wage growth, the current 31% standard is as much as people can afford. It isn’t likely these allowable DTIs will go up unless lenders want to start losing more money.

Down Payments

That leaves us with one final determinant of home prices. And this one cuts both ways. People are not good savers, and Ponzis don’t save anything. If people were saving and accumulating equity, the move-up market would be healthy and vibrant. In an era of unrestricted HELOCs, equity is squandered rather than accumulated. Have you noticed that the only communities where supply is abundant is the beach communities and other move-up markets? The demand is tepid in these areas despite low interest rates because potential buyers simply don’t have the down payments necessary to complete the sale. Unless we put some restrictions on mortgage equity withdrawal, people will not accumulate equity to support these markets. I anticipate the low end of the housing market will recover strongly while the high end continues to languish mostly due to the lack of sufficient down payments to push prices higher.

What conditions will your future buyer face?

For those who believe California house prices will begin a new phase of sustained rapid appreciation, what conditions will future buyers face that will cause prices to go up so much?

Will interest rates continue to go down?

Will incomes go up?

Will debt-to-income ratio standards be relaxed?

Will future buyers accumulate larger down payments?

One or more of those questions must be answered positively for house prices to go up. Appreciation doesn’t happen by magic. House prices must be bid up by future buyers, and based on the conditions I see, once the market reaches a new equilibrium (it is currently undervalued), future home price appreciation will be tepid at best.