Cheap Mortgages Are Hiding the Truth About Home Prices

Zillow's chief economist says the U.S. housing market is "in a carnival funhouse mirror" when it comes to affordability. Illustration by 731; Photograph by David Sucsy/Getty Images

At first blush, home buying looks quite affordable right now. New data from real estate website Zillow show that if a person earning the median income of $52,513 buys a home at the median price of $157,400, he would spend just 12.6 percent of his income on mortgage payments. That’s more than one-third less than the prebubble averages, when a mortgage on a median-priced home would cost about 20 percent of a median income.

Seems good, right? But that affordability is masking a problem—houses are overvalued. From 1988 through 1999, median home values averaged 2.6 times the median annual income. As the bubble kicked into gear, prices pushed up to almost four times income. With the crash, that ratio has come down—but not far enough, largely because incomes have been stagnant, if not declining, in recent years. Home values are now at three times the median income—that’s 15 percent higher than they have historically been, relative to what Americans earn.

Even so, the perception of affordability, combined with the fact that home prices compared with rental rates are at levels last seen in the early 2000s, is making it tempting for people to think now’s a good time to buy a home.

“We are currently in a carnival funhouse mirror,” says Stan Humphries, chief economist at Zillow. ”Homes seem quite affordable when at base they are not.”

Humphries says there’s a lot that worries him. The main tool the Federal Reserve uses to fix the broader economy—lowering rates—”could, if it hasn’t already, reinflate a bubble in the housing sector.” If incomes start to grow more, home values could move more into line with historic norms, but that’s not likely.

More likely, in his view, is that as rates rise and push mortgage payments higher, people are going to realize that homes—and not just mortgage payments—are overpriced for what the nation as a whole earns, which in turn could send home prices tumbling again.

Humphries’s outlook is unsettling. He says many people think that once home prices corrected from their overinflated bubble levels, the market would be back to normal. But that’s not the reality he sees. “It’s really a period of oscillations that will be disorienting for buyers and sellers, and I think we are far from done.”

He predicts volatility until at least 2016. Looks like the circus isn’t leaving town any time soon.