The recovery in the US housing market following the bursting of the housing bubble in 2007 has taken national home prices to new heights. One of the major contributors to the dramatic rise, particularly in the past several years, is the dearth of homes for sale.
Housing affordability may be significantly more challenged than conventional wisdom supposes. Adding to this is the likelihood that mortgage rates have a better chance of increasing rather than decreasing as the Federal Reserve begins to unwind its significant holding of mortgage-backed securities.
This is not to suggest home prices will decline (although that is possible). Rather, the pace of price increases will likely slow as affordability becomes ever challenging and the absence of declining mortgage rates will not "bail out" the market.
Although affordability has declined from its January 2013 highs, the current National Association of Realtors Affordability Index (NARAI) of about 145 implies a solid level of affordability. The NARAI measures whether a typical family earning the median family income could qualify for a mortgage loan on a national median-priced, single-family home.
However, the assumptions underlying the NARAI may significantly overstate the level of affordability. The NAR assumes a 20% down payment in its calculations. Based on the NAR's own data, more than 50% of non-cash buyers put down less than 20% on a home purchase. In addition, more than 60% of first-time buyers put down at most 6% on their purchase.
The NARAI has another significant shortcoming: it excludes the impact of real estate taxes and homeowner’s insurance – something every homeowner is faced with. Factoring in real estate taxes and homeowner's insurance significantly lowers affordability, particularly for higher-cost areas.
Once taxes and insurance are factored in, the median family income in a vast majority of markets as well as on a national basis is not sufficient to be considered "an affordable level of income."
Looking at affordability from another perspective, the monthly mortgage payment – or principal and interest (P&I) payment – as a percentage of median monthly income has increased substantially from 2012 levels. Although they remain well below 2005 peak levels of approximately 31%, these payments currently represent some 24% of monthly income, up substantially from 17% in 2012.
Another factor to consider is the impact mortgage rates have had on affordability. Despite higher rates, home prices increased significantly more than incomes did during the housing bubble. After a brief convergence to the average in 2009-2011, home-price gains once again have significantly outpaced incomes since 2012. Although some of this can be explained by the continued decline in mortgage rates through 2016, rates are unlikely to decline from current levels, and could increase as the Fed begins unwinding its significant holdings of mortgage-backed securities.
Meanwhile, the fact that rent has appreciated so substantially, particularly in the coastal and core urban markets, has led many "experts" to publicly state that "it is much cheaper to buy than rent in most markets." But data shows that this is not true across all metropolitan areas.
Although new capacity, job growth, and wage growth will likely be the key determinants of shelter demand, rent growth, and home-price appreciation going forward, because home prices have increased so significantly across the US, the relative affordability of renting in so many markets dispels much of the "cheaper to buy" argument.
Once the total cost of ownership is factored in – cost of obtaining a mortgage; saving for a down payment; maintenance; homeowner association fees (if applicable); water, electric, and other utilities –affordability is even more challenged.