Is an improving economy good for real estate?

This may seem counter-intuitive, but it is possible for homebuyers to be hurt if the economy improves. Of course, an improving economy has many positives for the housing market as a whole: decreasing unemployment, stabilizing household incomes and increasing consumer confidence levels. However, an improving economy also brings with it the likelihood of higher long-term interest rates.

One of the toughest jobs facing Federal Reserve Chairman Ben Bernanke is how to time any interest rate adjustments as the economy improves. Raise rates too soon and he risks killing the recovery. Wait too long and he risks significant inflationary pressures.

The interest rate conundrum also should be of concern to prospective homebuyers. Changes in interest rates can have a significant impact on a buyer’s purchasing power. To illustrate this impact, let’s do a simple “what if” case study. For purposes of this illustration, we need to define certain parameters. The first is to calculate a PITI. What is that? It is an acronym for Principal, Interest, Taxes, & Insurance. Essentially, it is your monthly house payment when you have the bank/lender escrow your annual property tax and insurance payments. Lenders use this figure to calculate certain ratios such as your payment to income ratio.

For many years (and even today) lenders have used a monthly payment to monthly gross income ratio of 28% as part of their underwriting process (there is also a total debt to income ratio of 36% but we’ll keep that for a later discussion). In essence, a mortgage lender wants to make sure a family’s monthly mortgage costs don’t exceed 28% of their gross income. The intent is to provide a safety cushion in terms of debt obligations (of course, during the sub-prime boom this safety cushion was sometimes more of a concept than an understanding standard).

So let’s take a typical purchase transaction and see the impact if interest rates begin to adjust:

Purchase Price: $250,000

Down Payment: 5% ($12,500)

Loan Amount: $237,500

Term: 360 months (30 years)

Insurance: $500 year

Property Taxes: 0.75% of value

Using these parameters with a loan interest rate of 5.25% yields a monthly house payment (PITI) of $1,502. Now if interest rates are to rise to say, 6.5% (a common interest rate just a few years ago) the monthly payment adjusts to $1,691. This is less than a $200/month change but the impact to potential buyers is significant. Remember the 28% ratio mentioned earlier. Using that ratio, a buyer would need an annual household income of approximately $64,353 under the 5.25% scenario. However, that increases to $72,482 in the 6.5% scenario. Thus, an increase of just 1.25% in the interest rate requires a nearly 13% increase in the buyer’s annual income.

Therefore, even if housing prices do not show any improvement as the economy recovers, if interest rates begin to rise, buyer’s purchasing power will begin to decline. For all those people waiting for the market to “bottom out” in terms of the overall price & interest rate environment, we may have reached the bottom in terms of overall purchasing power.

Of course, there will be those who suggest well if housing prices drop a bit more that will offset the impact. Fact is, not really. If in the example above the purchase price drops by another 5%, all things remaining the same, the buyer’s household income would still need to increase by 7% ($68,948) in order to qualify for the purchase. Home prices would need to drop another 12% from current levels for the buyer to simply break even. Given the reports of home sale activity stabilizing in many parts of the country (including here in Salt Lake and Davis County), hoping for another drop of 10-15% may be wishful thinking.