It’s no mystery that there has been a supply and demand imbalance for single family homes during the last year as many households contemplated urban flight (or suburban expansion), but this is only one of the factors that has caused home prices to surge so quickly.
How much did prices rise? According to a 20-city home price index (including BOS, SFO, and NYC), prices rose by a whopping 9.1% during the most recent period for which data is available (November 2019 to November 2020).
From the demand standpoint, there has clearly been (and remains) a sense of urgency among those who feel that they ran out of space when their universe contracted from their normal daily activities to, say, being trapped at home almost 24/7.
This is hardly surprising when many households have seen an “insourcing” of one (or even two) home offices, and children spending a dramatically reduced amount of time at school or in childcare.
Nonetheless, while the “space” issue is likely to be transient once people return to normal daily activities later in the year, I believe there are other potentially longer lasting reasons why home prices have moved so dramatically.
Why is that? Put simply, it’s about interest rates.
At the onset of Covid, the government reduced interest rates by 1.5%, and while that may not sound like much, even a small change in rates can drive a large change in the monthly payment of a long-dated loan, like a 30-year mortgage.
How much of a difference can it make?
If you go to a mortgage payment calculator you can figure it out pretty quickly.
As an example, let’s say that one year ago you planned to take out a $1M mortgage with a 30 year term, and 4.5% interest rate to buy a home. This would be a monthly mortgage payment $5,066.
However, if the interest rate declined by 1.5% (down to a 3.0% rate), the same $1M mortgage would have a monthly payment of $4,216 (or a reduction of $850 per month).
Why am I so focused on how this relates to home prices?
Because what this really means is that ALL homebuyers would now have an additional $850 per month of budget to play with.
Many of the people that I work with live in high-cost-of-living locations, and that means that they are often making compromises in finding what they want.
As a result, most would likely feel inclined to use that extra $850 per month to increase their budget rather than save that money, or invest it.
With the same monthly payment of $5,066 per month, and assuming lower 3% interest rate, how much home can this person now buy?
$1,201,601, and that’s exactly what I’m getting at.
Although this example doesn’t take into consideration the higher taxes or costs of maintaining a larger home, it represents a very large change in purchasing power for ALL buyers.
Therefore, those who are selling homes likely are (and should be) considering this with their realtor in how they arrive at their asking price.
That’s why if you’ve seen an increase in household income it can help you compete more effectively against other buyers who haven’t, but when everyone has more budget it’s likely to push up home prices.
At this point, many readers are likely asking, “that makes sense, but isn’t how much the bank is willing to lend me still really important?”
How much a bank is actually willing to lend you is very important, but that amount is determined by debt to income ratios, and they don’t make any consideration for wide differences in household spending and saving habits.
Looking at debt to income figures alone would only work if everyone had the same lifestyle, number of people in their household, and age of retirement. Quite a stretch, right?
That’s why when you’re considering the largest purchase decision of your life, it can be highly valuable to work with a financial advisor to update your financial plan and consider all of your financial priorities, rather than solving for one at the expense of all others.
If you’ve got questions, let’s talk.
This blog was written by Jeremy Bohne, Principal & Founder of Paceline Wealth Management. Paceline is a fee-only investment advisor serving clients in the Boston area, and on a remote basis throughout the country. Paceline specializes in helping tech and biotech executives, physicians, and those seeking financial planning services.