Are house prices really too high?

Houses feel expensive because an unusually large percentage of the payment is going toward principal amortization.

For the last few years, my monthly housing market reports rated most communities across Southern California highly, suggesting it’s a very good time to buy a house. Yet despite this dispassionate review of the math, most people who actually shop for a house feel like prices are way too high. Why is that?

Well, house prices are high. The federal reserve in conjunction with government officials reflated the housing bubble to restore collateral backing to lender’s bad loans. The housing bubble that peaked in 2005/2006 witnessed house prices 20 years ahead of their time. Reflating the housing bubble in 2016 still puts us 10 years ahead of where prices should be, which is one reason prices feel high.


Despite the high prices, the cost of ownership on a monthly-payment basis is not high — at least not historically high relative to rent, which is what largely determines affordability. But why does the math say one thing while our emotions say another?

At low mortgage interest rates, a larger amount of the payment is applied toward reducing the principal balance, and since I back this out of the cost of ownership calculation, very low mortgage rates reduce the cost of ownership more than if mortgage interest rates were higher.

The chart below illustrates this concept. I created a simple spreadsheet that calculated the payment on a fixed loan amount at various mortgage interest rates. Then I calculated how much of the initial payment applies toward principal. With those two numbers, I calculated the percentage of the payment that amortizes principal, which is the chart below.

As you can see, as mortgage interest rates drop, the percentage of the payment applied toward reducing principal rises very quickly. It’s not a straight-line relationship.


The percentage of a borrower’s income they can apply toward mortgage payments is generally limited to 31% of gross income. This cap applies whether rates are 3% or 13%. However, if the monthly payment were $1,000, at 3% nearly $400 is applied toward principal; at 13% only $20 is applied toward principal. Principal reduction is subtracted from the cost of ownership because it’s a forced savings, not an expense. Therefore, very low interest rates reduce homeownership costs even when the payment is the same.enlist_mortgage_drowning_underwater

Low house prices or low mortgage rates?

Whether low house prices or low interest rates are better is a matter of perspective. From a lender’s point of view today, low mortgage rates and high prices are better because they have so many underwater borrowers putting their capital at risk. Historically, lenders would prefer higher rates because interest is income, and they would rather make a higher rate of return by charging a higher interest rate, but the problem with underwater borrowers has shifted their preference.

From the perspective of taxing authorities, lower mortgage rates and higher prices are always more desirable. Municipalities get their revenues from property taxes, so they want to see land values as high as possible. Proposition 13 was supposed to prevent State and local governments from taxing people out of their homes, but instead, Proposition 13 prompts lawmakers to support policies that inflate house prices as much as possible to regain the lost tax revenue.

Most economists erroneously argue in favor of lower interest rates generally as a stimulus to the economy; however, low interest rates cut both ways because the interest cost to a borrower is income to a lender. The federal reserve’s zero interest-rate policy has crushed seniors living on fixed incomes. Their policy takes money away from seniors, which prevents them from spending this money on goods and services, and instead diverts this money to underwater homeowners who enjoy a debt-service subsidy. Where is the economic benefit in that?


So that opens the larger question about which is better, lower prices or lower interest rates? Both lower the monthly cost of ownership and result in more disposable income. Obviously, the banks prefer higher prices to recoup their capital from their bad bubble-era loans, so they are offering 3.5% interest rates to boost house prices. Most buyers would prefer lower prices, but since the banks make the rules which determine market prices, low interest rates and high prices prevail in the market.

From a homebuyers perspective, low rates or low prices depends on how they acquire the property. All-cash buyers would far prefer lower prices because they gain nothing from inexpensive debt they don’t use. From a financed buyer’s perspective, lower interest rates are better even if they pay higher prices.appreciation-amortization

If a financed buyer holds a property for 30 years and pays off the debt, how they financed the property doesn’t matter; however, if they sell the property before paying it off entirely, low mortgage rates are superior because they amortize faster. Assuming equal rates of appreciation during the holding period, a financed buyer using a low mortgage rate will accumulate more equity than a buyer who pays a higher mortgage interest rate; that’s the math. The key question is whether or not appreciation rates would be the same.

Buyers who purchase during a period of high mortgage rates may get the boost in appreciation from declining rates, so they may enjoy more appreciation than a financed buyer who buys today when mortgage rates are low. Over the last 30 years, declining mortgage interest rates added significant appreciation above and beyond the growth in income. The current generation of buyers won’t get the same boost.

Low mortgage rates build equity faster through amortization but slower by appreciation. High mortgage rates build equity faster by appreciation but slower through amortization.

Which do you think is better?