According to data by Redfin, the median price for a single-family home in Santa Clara County peaked in April 2022 at around $1.9M. That had dropped to approximately $1.6M by August 2022, about a 16% drop. Note: August 2022 is the latest data available. 

While that is a significant drop, affordability probably dropped even more. According to National Association of Realtors data, a nationwide measure of housing affordability is down about 50% in 2022. Note: the latest available data is July 2022. 

What’s the biggest driver of the affordability index? It turns out that the formula is a function of monthly mortgage payments divided by income. That means if you hold income constant, interest rates go up, and housing prices must decrease. If housing prices don’t come down enough to offset the monthly cost of home ownership, then the affordability index drops. 

How much have mortgages gone up? The average mortgage rate at the start of 2022 was just over 3%, and today that number is about 6.7%. Note: latest data available is September 2022. 

I thought it might make sense to take a deep dive into what this means to someone in the market today in Santa Clara County. Let’s look at some real numbers and see how they play out. 

Base Case: A potential scenario from early 2022

Let’s compare April 2022 as our baseline. Using $1.9M as a purchase price, a down payment of 20% would be $380,000 and a mortgage of $1,520,000. Assuming an interest rate of 3.5% for a 30-year fixed mortgage, you would have a monthly principal and interest payment of $6,825.

Scenario 1: Lower purchase price as interest rates go up

Let’s assume you have the downpayment in cash, so you still have $380,000. (If you were holding your downpayment in the stock market, you likely have quite a bit less today.) Let’s also assume that you can still afford $6,825 as your monthly payment but can’t stretch farther than that. If the interest rate has increased to 6.5%, your maximum mortgage is now $1,079,865. That makes your maximum purchase price $1,459,865, or $440,135 lower than when the rate was 3.5%. That is a 23% drop in the purchase price of the home you are reasonably able to afford. 

Table 1 shows how rapidly the potential purchase price falls when interest rates rise (assuming that the monthly obligation stays the same and the downpayment is unchanged). 

Scenario 2: Higher monthly costs as interest rates go up. 

If we look at this from another angle and keep the house price constant, the picture is even worse. In this scenario, let’s assume we keep our sights on a $1.9M purchase price, keep our down payment the same, and the only thing that changes is the monthly payment. The same mortgage of $1,520,000 at 6.5% results in a monthly payment of $9,607, which is a whopping 41% higher than the baseline. 

Table 2 shows how rapidly your monthly expenditures will rise when interest rates rise (assuming that the purchase price and down payment remain unchanged). 

Where do we go from here?

Interest rates are likely to go even higher from here. The Fed recently indicated that they would raise interest rates even further, at the possible cost of increasing the unemployment rate and potentially causing a recession. Based on the guidance the Fed gave, we could easily see 30-year mortgage interest rates in the 7.% to 8.5% range.

Synopsis

If we compare the amount that housing has fallen (down about 16% YTD) with the drop in the affordability index (down about 50% YTD), it is clear that something is amiss. The analysis from Scenario 1 and Scenario 2 indicate that housing prices should have dropped somewhere in the range of 20% to 30%, and this has not yet played out in actual market data. Part of this is the high transaction costs associated with buying and selling a home. Unlike a share of publicly traded stock, which you could sell one day and buy back the next in your brokerage account, selling a home is a much more involved process (not to mention that when selling, you need to find someplace else to live). There is also the idea of “anchoring,” which means that sellers can anchor on a particular price and be hesitant to sell until they can get that price. 

Regardless of the reason, it is almost certain that interest rates will continue to rise above current levels, that housing prices will continue to trail the affordability index, and that the outlook for housing is anything but certain. 

Footnotes: 

The National Association of Realtors Housing Affordability Index formula is:
 ((Monthly Payment * 12) / Median Income) * 100