When will Housing Prices Bottom Out?

There is much speculation on when home prices will finally bottom out and start rising again.  Various government programs have been attempted that offer incentives for home buyers but they only have the effect of causing people who were going to buy a home anyway to move up their buying decision.  When the program ends the increase in sales ends with it and home prices continue to fall.  Because consumers tend to spend less when the price of their home is falling, both because they are unable to borrow from their home to pay off credit cards–freeing them up for more spending–and because they feel less rich and therefore are less willing to make purchases and go on vacations.

Likewise, attempts to halt the slide by having banks “reset” loans that are in default, forgiving missed payments, lowering the principle, and adjusting the terms of the loan have met with similar failure.  In fact, because the loan is reset the buyer starts to feel entitled to not paying if he feels that the loan is somehow unfair.  Even though he felt the price of the home was fair when he bought it, because he has seen his loan reset he fells that he deserves the value to be lowered if home prices continue to fall.  This results in a cycle of default, reset, and default, each time driving the home price further down.

Home prices, like stocks have a fair value.  Unfortunately, during the housing bubble this fair value was forgotten as individuals paid more and more for houses simply because they felt, no matter what they paid, that they could later sell the house for even more money. In the least they thought that the price of the house would continue to increase, so if they did not buy now they might never be able to do so. 

Payments through traditional 30-year fixed rate loans were above the buyers’ ability to pay.  In order to pay for the houses, individuals first began taking out took out 0% down loans since a 20% down-payment was out-of-the-question.  Later, Adjustable Rate Mortgages were used since they started at a lower interest rate.  Then individuals started taking out interest only loans where they only paid the interest, and even then the loans were taken out at teaser rates such that the interest rate was only low for the first year or two.  Finally they started taking out Option ARMS which allowed individuals to pay less than the interest amount, such that the amount owed actually increased over the first several years of the loans. 

Because they were not able to afford the payments once the loan was reset and they needed to start paying off the principle, many went into default.  This caused banks to stop making loans because they could no longer sell them to third parties, and the price of houses could no longer increase.  At this point they began to fall back towards fair value as homes are foreclosed upon and buyers reduce the bids they make for houses.  Even if they were willing to pay a high price for a home the banks are not willing to make the loan.  Until houses reach their fair value they will not stabilize and the various programs simply have the effect of delaying the inevitable.

I would submit that the fair average value of a house for a given area is about equal to the price that would allow the average  person living in that area to purchase that house and pay no more that 30% of his net income (after taxes) for that house.  Currently home mortgage rates are extremely low, owing to the fact that the Fed Funds Rate is also extremely low and all interest rates are tied to the Fed Funds Rate.  The current rates for a 30-year loan are around and unheard of 5%. 

In the table below I present the payment, net income, and total income required to purchase houses of various prices assuming an interest rate of 5%on a 30-year loan.   Note that the net income required is found by dividing the yearly payments by 30%.  The total income required was calculated by assuming various tax rates (income, Social Security, etc…) ranging from 25% to 50% of total income, depending on income level.

 Table 1: Income required assuming a 5% loan rate

Home Price Monthly Payment Net yearly Income Total Yearly Income
$100,000.00 $537.00 $21,480.00 $28,640.00
$200,000.00 $1,074.00 $428,960.00 $57,280.00
$300,000.00 $1,610.00 $64,400.00 $99,077.00
$500,000.00 $2,684.00 $107,360.00 $165,169.00
$1,000,000.00 $5,368.00 $214,720.00 $429,440.00

So, for $100,000 houses to sell, there needs to be enough people in the area who make at least $28,640 per year to meet the supply.  If there are not, the price will need to continue to drop until there are enough people.  Likewise, if there are a lot of $500,000 houses on the market, unless there are a lot of people who make at least $165,000 around looking for a house the prices will continue to fall (or the owners will need to stay in the house and not sell until incomes increase.  Note that an income of about $425,000 is needed to comfortably afford a million dollar house.

Some may say that requiring the payment to be no more that 30% of one’s net income is too restrictive a requirement, but note the effects of the recent bubble in which people were buying houses with much higher payment ratios.  While there may be some who do buy houses at higher levels of leverage, doing so puts them at great risk since any deviation in their income at all or an unexpected expense such as a car breakdown or illness can easily lead to a foreclosure, which again will drive down the prices of houses in that price range.  Such buyers will also probably feel very “tight” financially with little income left over for other expenses.

The rate of taxes has the effect of suppressing home prices.  The total income required to afford a home increases as tax rates increase because paying a greater percentage of income to taxes has the effect of lowering net income.  Because the current government drive is to raise taxes (sun setting the Bush tax cuts and enacting significant new medical entitlements), we should expect the fair value of homes to continue to fall as states and the federal government raise taxes to cover budget deficits and increase social programs.

If rates return to more historic values–either because the Federal Reserve raises them to hold down inflation when the economy starts to pick up or inflation does return and causes rates to rise on their own–the effect on the fair value of homes is even more chilling.  (Note that increases in inflation cause interest rates to increase since lenders need to raise the interest rates they charge just to get back the same effective rate of return–they are being paid back in dollars of lesser value than those that were lent).

Table 2 gives the net incomes and total income levels required if the 30-year mortgage rate rises to 8%.  Note that now the total income required to afford a $300,000 house increases from just under $100,000 to over $135,000.  Unless big raises at work come as well (which don’t look to be in the cards anytime soon), look for housing prices to fall if and when rates are raised unless they stay low long enough for salaries to catch up with housing prices.  Note that the effect is particularly severe because the higher income required means that those able to afford even a $300,000 house will be pushed into the higher tax brackets, so their total income must be even higher than before.

 Table 2: Income required assuming an 8% loan rate

Home Price Monthly Payment Net yearly Income Total Yearly Income
$100,000.00 $734.00 $29,360.00 $39,147.00
$200,000.00 $1,468.00 $58,720.00 $90,339.00
$300,000.00 $2,201.00 $88,040.00 $135,446.00
$500,000.00 $3,669.00 $146,760.00 $266,836.00
$1,000,000.00 $7,338.00 $293,520.00 $587,040.00

So in conclusion, no matter what policy gymnastics the government or banks do, housing prices will continue to fall until they hit the fair value, which is determined by the income level for the area.  If taxes are raised, the value of houses will fall.  If interest rates are raised the value will fall even faster.  The best course would be to stop trying to hold back the bursting of the dam with various gimmicks and allow it to burst so we can clean things up and regain a more sustainable path.  To do so is like trying to bail the Titanic with an ice bucket.

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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.


  1. I think the analysis is too restrictive, particularly for higher income earners. You do not need to make 600k to afford 1mm house or make 1.2mm to afford 2mm house.

    Higher income people devote less percentage of income to essentials such as food and heat.

    I don’t disagree that people making 100k cannot afford a 500k home but this analysis is too restrictive.

    One of the guys I bank just built 3mm house (crazy this year I know) and he makes 1.2mm consistently year over year with his business. He can easily afford this house despite your analysis. And there is 2.5mm loan associated with this house.

    • Thanks for the comment.

      There is definitely more wiggle-room for high earners that mid and low-earners. Someone making $40,000 would have a tough time paying more than $10,000 per year for rent or a mortgage and still afford clothes, food, gas, energy, and other essentials. As income increases there is more flexibility so a greater share of income could be directed towards a home, although many high earners end up tying themselves down with so many other expenses (cell phones, black berries, cars, boats, vacation homes, time shares, remodelling, and wine clubs) that they end up living paycheck to paycheck as much as anybody else.

      That said, even the high earners should not be putting more into their personal residence than about 25% of their income. If they do, they are putting too large a share of their income into a single asset that asset will grow in value, on average, at no faster a rate than inflation. Throw in property taxes, repairs, and upgrades over the time in the house, which mostly scale with the price of the house, and your high earners may end up stepping down substantially in quality of living in retirement.

      As a final point, the analysis I gave is based on a simple model. Obviously, with any model there are refinements that can be made to improve model accuracy, so I could scale available percentage of income up with income level. I’ve found in my engineering work, however, that a simple model can often give an answer that is 90% of the way to the right answer and is good enough for much design work. Getting the final 10% often costs many times what getting the original 90% cost and is not always worth the expense.

  2. As another note, interest rates are currently much closer to 5% (top table) than to the 8% table you were referenceing. For your client they would be about 6% since he would need a jumbo loan.

    From the top table, at 5% he would need about a $1.05M income to confortably afford the $2.5M loan. At 6% he would need to make a little more. That actually makes my estimate and his income pretty close.

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