Low Interest Rates Do Not Make Homes Affordable

By David Ning on 4 August 2010 (Updated 1 August 2011) 11 comments

Does the sales price of your home matter if the mortgage rate is low enough?

If you ever thought about buying a home, the recent all-time low mortgage rates must be enticing. And this is exactly how the government wants everybody to feel, by the way. In an effort to keep homes affordable (as they claim), the federal reserve is driving down interest rates to record lows. But is what they are doing helping? Let's take a look.

Just a short couple of years ago, interest rates were at 6 percent. For a $300,000 mortgage, the payment would have been $1798.65 a month. With the interest rate at 4.5 percent, the monthly payment drops to $1520.06. So far so good, because it costs us less to own our home.

But wait a minute.

Most people don't just refinance and lower their payment. These days, with rates at 4.5 percent, roughly the same monthly payment ($1798.73, to be exact) could get you a $355,000 mortgage. So what do people do? Instead of buying a $350,000 home with their down payment and loan approval letter, they shop for a $400,000 home. And who can blame them? An extra $50,000 almost always gets them a nicer place. Sometimes, it would actually allow them to pay more for a house than they otherwise would.

For example, they might have been able to get the house for $350,000 if they tell the seller that the offer is all they are approved for, but if a buyer can muster up $400,000, he might end up offering $360,000. Same house, higher transaction price. Having a lower interest rate also allows more people to qualify for a home. This is a good thing for someone who couldn't afford the payment before, but it drives prices higher because of more demand, ultimately lowering affordability for everybody.

In other words, lowering interest rates gets more people thinking about buying a home and drives up demand. Most of the time, that's a noble and worthwhile goal, since home ownership is still a dream of many. But as you've witnessed in the last decade, allowing more people to own homes mindlessly is just reckless. What we really need to do is make homes affordable so financially responsible people can actually afford the payments, which is only achievable through lower home prices.

I'm a homeowner too, so the selfish side of me is thinking that high-priced homes are good. But for the economy to grow and our country to be a place people want to be in the future, nice homes need to be affordable without government intervention. Unaffordable home prices will never get us there. Please allow homes to be affordable again for the hard-working American.

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Guest's picture

So once rates go up, that $400k home will drop to $350k and they will get it then, it all evens out.

Guest's picture

Odd... I started writing and then the page reloaded. I hope this doesn't post twice..

I wrote a post that included a bit about how a higher credit score could save hundreds of dollars per month because of lower interest rates. The math is the same (but the reason is different). You have a number of options with that money, but my favorite is not to buy more house, but to invest the difference on a regular basis. Even conservatively invested, a difference of a few hundred dollars per month could net you six figures in an account 30-years later after taxes. This can make up a lot of the interest you're paying over the years and, depending on the actual numbers, replace the interest paid! I understand the urge to buy "more house" but would be hesitant to buy more house "than I needed" just because the monthly payment is the same. I've heard somewhere recently (don't remember where but it's not an original...) that rich people as "how much" and poor people ask "how much is the monthly payment." I think that applies here (i.e. don't get married to a monthly payment - buy an appropriate house. If you can save money per month because of good credit and low rates generally, great - put that money to work for you somewhere else). That's my take at least.

Guest's picture

I am confused by this article.

The author argues that home affordability is bad because it leads to increase in demand which, in turn, leads to increase in price, which is bad because homes need to be more affordable for the hard working Americans because home affordability is good... Wait, so which is it? Is home affordability good or is it bad?

And, how can the author be against both free market AND government intervention? What else is out there? Last decade's "reckless" home buying, yeah that was free market at work. A lot of people blamed the government for NOT intervening. If I'm remembering my econ lessons correctly, interest rates are controlled by the Federal Reserve, which, despite being called "the Fed" is not a government agency. But, for the sake of argument, let's say the government is responsible for the lower interest rate... So, the author is against Free Market, aka reckless home buying of the last decade. He claims that in order for the economy to improve, homes needs to be more affordable. The Feds step in to make that happen and he's against that as well.

Basically, it seems to me that the author is arguing against the very nature of supply and demand, and that's like arguing against gravity. It's natural it just happens there's no real way to control it. There's a reason why recessions happen in 7-10 year cycles. The only way to even try to control supply and demand is with government intervention.

Guest's picture

That is one of the problems these days is that instead of buying the cheaper house everyone tries to stretch into something a little bigger. Housing can be real affordable, but we keep pushing it to the limit instead of backing off and taking the cheaper mortgage. Well that is what I just did, we downsized and it was the best move we could have made.

Guest's picture

This post argues the opposite of the headline. Lower interest rates do make homes more affordable according to the article. They may not make home buyers more responsible, but the current tighter lending standards do that.

Guest's picture

A lack of understanding of basic financial principles and an infusion of emotion is at hand in the real estate market. The facts don't outweigh the economies of scale so house prices will remain inflated as long as inexperienced home shoppers exist plain and simple!

Guest's picture

Very insightful--lots of points that never occurred to me before...

Guest's picture

The last decade was not the result of free market reckless home buying. Government intervention and meddling into the housing and credit markets is exactly what is responsible for the "crisis". Gov't intervention has slowly eroded the ability of the banks/lenders to determine credit risk by the following:
Namely the Community Reinvestment Act (CRA) signed into law by Jimmy Carter in 1979 and given more teeth by President Clinton which essentially forces banks to lend to less creditworthy borrowers. What this law does is force banks who take FDIC insurance to be subject to the CRA, pretty much stepping on their right to make decisions about lending and borrowing and forcing them to lend to lower income people who they, the lender, deemed not creditworthy.
Two other factors are major players in this category: government sponsored enterprises (GSE's) called Fannie Mae and Freddie Mac. Fannie and Freddie were both lenders and buyers of higher-risk loans from banks who were forced by the CRA to lend. Banks initially forced to lend, no longer minded lending to poor credit candidates because they knew they could unload the assets, in part, onto these tax-payer supported institutions thus reducing the risk the lender or bank was taking in making the loan.
You mention the Fed, who you are correct is not a gov't agency, but rather the legal and monopolistic (by Government mandate see: Federal Reserve Act 1913) currency issuer in the U.S. They set interest rates. Interest rates set by the Fed go a long way in determining how credit and currency use. This determines how people, the public be they lenders or borrowers of credit, act in relation to utilizing and lending credit.
In summary, you're laying blame at the feet of the free market for the housing crisis is wrong. The housing crisis of late was caused by meddling government regulation and a free market on housing, money, credit, etc have not existed for quite a long time.

I perceive the author to be saying this: The government is trying to prop up the failing housing market by enticing people to buy. And worst they enticing people to buy houses they can't afford in order to continue the bubble. However, the author points out as a home owner he wants prices to stabilize and stay up because it affects the value of his own home. As a prospective buyer one would want prices to go down because they'll get more bang for their credit buck. And yet as prices dip and credit is still loose the psychology of it is that people will shop for bigger, more expensive homes because the credit is cheap.
The author still seems to miss the point when he says home ownership needs to be one of responsibility and affordability. Unfortunately, the situation as it is now, the gov't trying to reinflate a bubble, neither the former or the latter will occur. The housing market needs a serious correction. That correction is going to screw a lot of current homeowners who bought in the last 10 yrs especially ones who overbought, overpaid. Despite the interest rates set so low, housing prices still aren't low enough to warrant snatching up real estate.

Guest's picture

Great point, it is often wise to buy a house well within your means, and not max out to what the bank tells you what you can afford. Remember, they are a business, and will try and make as much money as they can off of you. A higher down payment and a smaller loan means less interest out of your pocket.

Guest's picture

I agree with you, however, I disagree with your idea that low rates don't make homes affordable. Homes are incredibly affordable now so long as you are financially responsible and don't over spend. Plus, if you're planning on being in your house for a while - which you should be if you're buying - purchasing the home make sense.

Don't get me wrong, I've never thought of home ownership as a worthwhile investment, but that still doesn't mean homes aren't affordable.

Guest's picture

Good points. I don't own a home, but I'll be ready to buy in a year or two. Now, should we think about buying a home like buying a car? For example, I wouldn't buy a new $30,000 car just because the dealership gave me a 0% interest rate. I'd buy that car if I could afford it. Does it therefore make sense to buy a house that's not within my price range just because the interest rate is low and I could afford the monthly payments? I don't know the answer to that. The conventional thinking about this seems to be that cars depreciate and homes appreciate, so we are supposed to buy the most house we can afford because it will pay off in the end. Does it pay off in the end or are people just deluding themselves into thinking that it pays off in the end because they are rationalizing their home purchase?