That Starter Home May Be A Nonstarter

It's practically an article of faith among many housing industry execs. Some Federal Reserve officials are believers as well: The housing market will be able to weather the rising interest-rate cycle that the Fed kicked off on June 30 because the economy is strong and the job market is healthy. By this reckoning, buoyant growth will boost wages and salaries, giving home buyers the extra money they need to cover their increased borrowing costs and so buttress housing.

Well, hold on. It turns out that it would take a sizable increase in income to offset the effect of rising interest rates on housing affordability. What's more, first-time home buyers, who are already stretching themselves financially to purchase their houses, look particularly vulnerable now that borrowing costs are increasing. And if those buyers disappear, their absence could have an outsize impact on the market because they provide the new demand that gives the market its juice. The bottom line: Housing may be in for a rougher ride than some optimists think.

A quick look at the housing affordability index compiled by the National Association of Realtors shows why. The index is widely considered by economists the best measure to judge how much house the average American can pony up for. It assumes home buyers fork out a 20% downpayment and don't spend more than 25% of their monthly income on mortgage payments.

So what will happen if mortgage rates rise by 1 1/4 percentage points by the end of next year, as the Realtors and other analysts project? Turns out median family income would have to climb nearly 15% to keep houses as affordable as today. Yet incomes rose just 3% over the past year.

To be sure, the average family that already owns a house would still have enough dough to move if they chose to, even if interest rates rise as much as expected. But first-time home buyers, the lifeblood of the market, could find themselves out of luck. According to the Realtors' index, a 1 1/4 percentage point increase in mortgage rates would mean that median-income first-time buyers would need an income of $42,000 to qualify for a typical $145,000 starter house. Yet today the median income is only $31,000. They could always borrow more, of course, or opt for an adjustable rate mortgage to try to keep payments down. But if they don't want to go that risky route, they might have to settle for a fixer-upper or a condo. Or they could be priced out of the market altogether.

The wild card in all this is what happens to house prices as interest rates rise. House prices have increased sharply over the past few years, as the market has boomed. In some areas on the East and West Coasts, the price hikes have been so sharp that first-time buyers already find it tough to find something affordable. Add to that increased borrowing costs as interest rates rise, and a recipe may be brewing for some pretty steep price declines. While nationwide price drops in housing are rare, history suggests that regional markets can suffer hard landings.

Put it all together and it's not a pretty picture. Perhaps the best that anyone can hope for is that the housing market stagnates for a while until incomes rise enough to make homes more affordable again. But after the recent boom times, a flat market could feel pretty crummy.

By Rich Miller in Washington

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