interest rates and the housing market

To my mind, the oddest thing about residential real estate in all the markets around the world I’ve dealt in is that purchase price is not the primary consideration for buyers. Rather, what is top of mind is the monthly payment–mortgage interest + return of principal + taxes and utilities. Typically, people buy the most expensive property they can finance.

In the US, the traditional rule of thumb is that total monthly payment should not exceed 28% of the buyers’ gross income. I’ve shortened this rule to: the interest payment, which is by far the dominant element in the early years of almost any mortgage, can’t be more than 25% of gross income. (Overall, I’ve found over the years that taking a first step of making gigantic simplifying assumptions and seeing what they imply is, for me, the best way to get started. Refining can come later.)

Let’s assume the buyer(s) have yearly income of $100,000. This means maximum interest expense of $25,000. At 3%, the most that can be borrowed is $25,000/.03 = $833,000. This implies a total price of $1,040,000 ($833,000/.8) and, therefore, a cash down payment of $207,000. When my wife and I bought our house long ago (interest rates at 17%), our biggest problem was getting the $8,000 down payment we needed.

Assume rates rise to 6%. Interest expense of $25,000 implies maximum loan principal of $417,000. and total price of $520,000.

In other words, our imaginary buyer(s), who could afford a million-dollar house a few months ago, can only get financing for a $500,000 house today.

The biggest implication–a cooling housing market.

More tomorrow.

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