How to make homes affordable for millions of Americans again

• Since 2000, the average 30-year fixed mortgage rate has been at its highest level, making home affordability the worst it has been since at least 1989.
• Since 2020, the National Association of Realtors Housing Affordability Index has dropped by almost half.
• To stimulate the housing market, economists suggest a combination of declining mortgage rates, increasing incomes, and stable or lower home prices, as well as increasing new home construction inventory.

Last week, when mortgage rates hit a 23-year high, markets and social media erupted with the question: Is the American dream of home ownership, children, and backyard barbecues now dead due to housing affordability?

Since the ultra-low interest rate days of 2021, the National Association of Realtors reports that housing affordability has dropped by nearly half.

The median family was already $9,000 short in August of the income needed to buy the median existing home, and the recent surge in rates has moved another five million U.S. families below the qualification standard for a $400,000 loan, according to John Burns Real Estate Consulting. At 3% mortgage rates, 50 million households could get a loan that size. Now it’s 22 million.

Although the recent decrease in treasury bond yields has slightly lowered the 30-year fixed mortgage rate to around 8%, a quick solution is not available.

In 2020, the qualifying yearly income for a median-priced house was $49,680, according to the NAR. Now, Redfin reports that the figure is more than $107,000.

The bond-market maven, Mohamed El-Erian, an advisor to Allianz among many other roles, stated that the numbers are stunning and make house affordability even more challenging for American families, particularly those trying to buy their first home.

Lawrence Yun, the chief economist of the National Association of Realtors, expressed concern about a recent development in America, stating, "It's a very troubling trend."

According to Yun, the three factors that determine affordability are family income, the cost of the house, and the mortgage rate. Since 2019, incomes have increased, but the bigger challenge is the rise in interest rates. When rates were low, they masked a surge in housing prices that began in late 2020, driven by people moving to areas like Florida, Austin, Texas, and Boise, Idaho, to work remotely. Now, the increase in rates is putting a strain on affordability, even as incomes rise and housing prices remain relatively stable.

Mark Zandi, Moody's Analytics chief economist, stated that at the current 8% mortgage rate, mortgage payments are 38% of the median income. For mortgage payments to be reduced to 5.5%, the median-priced home must fall by 22%, or the median income must increase by 28%, or a combination of both variables.

The demand for adjustable-rate mortgages has surged to its peak in a year, coinciding with a decline in overall mortgage applications.

What needs to change to make housing affordable again

The road to recovery for all three indicators is challenging, and it's a far cry from the current situation. A few statistics demonstrate this.

The National Association of Realtors calculates housing affordability using its 34-year-old Housing Affordability Index (HAI). This index determines how much income the median family needs to afford the median existing home, which currently costs about $413,000. If the index equals 100, the median family can buy that house with a 20% down payment while paying 25% of their income toward principal and interest.

The median family typically has a 38% cushion, with a long-term average of 138.1. This is based on the all-time high of 213 in 2013, which occurred after the housing bust and 2008 financial crisis.

Right now, that index stands at 88.7.

Using NAR data, a few scenarios demonstrate the significant gap between affordability and the average between 1989 and 2019. To bring it back into a more typical range, as the national average for the 30-year ticked lower to 7.98% on Tuesday, it would require a significant change in the market.

• In order to reach the historical average, rates must decrease to 3.55% if home prices remain stable.
• If prices grow 5%, rates need to fall to 3.16%.
• If incomes increase by 5%, rates must decrease to 3.95% to maintain the same prices.
• To maintain an 8% mortgage rate, median home prices must decrease by 35% to reach $265,000.
• If prices remain constant and interest rates remain at 8%, income must increase by 63%.

The challenge of restoring affordability to its previous level is greater than the numbers suggest.

The hyper-low interest rates of the pandemic brought about affordability for people, but it may take more than just a return to those rates for this level of affordability to come back again.

Since 2020, home prices have increased by 38%, according to the NAR, while average interest rates have jumped from 3% to as high as 8% last week, resulting in a 167% increase in monthly payments on a newly bought house, amounting to $1,199 per month.

Higher wages are a plus, but not enough

Since 2020, median family incomes have increased by 16% to over $98,000, but this is not enough to close the affordability gap without requiring a larger portion of household income to be allocated towards the mortgage, according to Zandi.

According to Fannie Mae's chief economist, Doug Duncan, the direction of monetary policy will not solve the housing problem, as incomes are not the only factor. The Federal Reserve has been raising interest rates because it believes that wages have been growing fast enough to reinforce post-Covid inflation, but year-over-year wage gains have slipped to 3.4% in the most recent job-market data, and the Fed would like to see wage growth be lower.

If home prices decline, it may not be sustainable unless America constructs millions of new homes.

Despite the assumption of a big price correction following the surge in prices from 2019 to early 2022, it hasn't happened. In most markets, prices have even started to increase slightly. According to the realtors' association, the median price of an existing home dropped by more than $35,000 in late 2022 but has since risen by $45,000 since its low in January.

Not enough new housing in America

Despite a decrease in the number of homes available for sale, the laws of supply and demand have not been significantly impacted. Despite the affordability challenges, buyers are still competing for a limited number of homes, which has kept prices relatively stable.

Gen X is already locked into 3% mortgages, so it's up to the builders to address the aging population's needs, as Boomers are following through with their plans to age in place, according to Duncan.

Daryl Fairweather, Redfin's chief economist, stated that the builders are a problem. Although they have been increasing profits this year and the industry has grown by 41%, they have not adequately addressed the long-term housing shortage, estimated to be 3.8 million homes before the pandemic, which is likely to have increased since.

Builders have commenced work on 692,000 new single-family homes this year, and 1.1 million including condominiums and apartments, according to the statement. This implies that it will take nearly four years to replenish the supply of houses, excluding new household formation. Meanwhile, the construction of apartments is already slowing down, and some builders are withdrawing from mortgage buydowns and other strategies they have employed to stimulate demand. PulteGroup's CEO disclosed to CNBC this week that the company has been purchasing mortgages at an effective rate of 5.75%.

On Wednesday, it was announced that new home sales for September exceeded expectations by 12.3%, despite the fact that these sales figures include contracts signed in September when mortgage rates were lower than the current rates.

It is predicted that more buyers could emerge due to reasons such as the millennial generation reaching peak home buying years, with the largest birth cohorts reaching the average first-time purchase age of 36 years around 2026. If mortgage rates decline, it is predicted that more buyers will return to the market, but this may push prices back up towards previous peaks, as seen earlier this year when mortgage rates dipped to 6% in early March.

Fairweather stated that we need a few more years to continue building at this pace, but the demand cannot be sustained due to high interest rates.

The Fed and the bond market are big problems

Two issues are affecting mortgage rates, according to economists. One is the Fed's reluctance to declare victory over inflation too soon, and the other is the bond market's heightened sensitivity to inflation, even as the overall rate of price increases has decreased.

Despite a decrease in trailing 12-month inflation from 6% in February to 3.1% in March, mortgage rates remain 2 percentage points higher. This is despite the fact that the Federal Reserve's target for core inflation is only 2%, and a measure of inflation excluding shelter costs has been below 2.1% since May, despite reported declines or smaller gains in housing prices by private sources.

Since then, the Fed has only raised the federal funds rate by three-fourths of a point as part of its "higher for longer" strategy, which involves maintaining higher interest rates rather than aggressively adding more rate hikes. The primary reason for the recent surge in mortgages is the bond market, which has increased by as much as 47%, resulting in a full 1.6 percentage point increase. Additionally, the traditional spread between 10-year treasuries and mortgages has widened to more than 3 percentage points, with a range of 1.5 to 2 points being the traditional norm.

Fairweather stated that justifying the increase in rates is difficult, and it could be due to volatility.

Few economists or traders anticipate the Fed lowering rates to aid the housing market. According to the CME FedWatch tool, even if the central bank ends or nearly ends its rate hikes, it won't begin cutting rates until March or May, with only modest reductions. Spreads are likely to remain wide until short-term interest rates fall below long-term treasury rates, as predicted by Duncan.

It could take until 2026 to see a ‘normal’ real estate market

A combination of higher wages, lower interest rates, and stable prices is necessary to restore affordability to a comfortable level, according to economists. This combination may take until 2026 or beyond to come together.

According to Zandi, the market is in a deep freeze and can only be thawed out by a combination of lower prices, higher incomes, and lower rates.

In some regions, affordability is even more broken than nationally, with markets like New York and California being particularly unaffordable, and moderate-income markets like Phoenix and Tampa experiencing the same level of unaffordability as parts of California earlier this year, according to NAR.

The market will remain the domain of small groups of people until conditions normalize. Cash buyers will have an even bigger edge than usual. Yun advises that if a buyer is willing to move to the Midwest, the best deals in the country can be found in Louisville, Indianapolis, and Chicago, where relatively small rate cuts would push affordability near long-term national norms. However, it will be a slog across the nation.

Yun stated that it is unlikely that mortgage rates will decrease to 3%, and we can hope for a return to 5% at the most.