As of August 2023, mortgage rates have hit their highest point in over two decades, with the national average for a 30-year fixed mortgage reaching 7.53%. This sharp rise follows an all-time low of 2.65% in January 2021. The increase in mortgage rates has had a significant impact on home affordability, which is now at levels that are far above historical norms.

In comparison to just two years ago, mortgage rates have risen sharply, reflecting broader trends in the financial markets, particularly the U.S. Treasury 10-year note yield, which has climbed to 4.23%, its highest since the pre-recession period of 2007. With mortgage rates at their current levels, homeownership has become increasingly out of reach for the average American household.

The State of Housing Affordability

At present, the median home price in the U.S. stands at $416,000, while the median household income is around $77,290. Historically, the price-to-income ratio has been about 3.6, meaning homes were generally priced at about 3.6 times the median income. Today, however, homes are priced at 5.4 times the median income, a 50% premium above historical norms.

However, most homebuyers do not view the affordability of housing in terms of the home price itself. Instead, the focus is on the monthly mortgage payment and the ability to comfortably afford those payments. Lenders typically require that monthly mortgage payments not exceed 28% of a household’s income. For the current median income, this means a family can afford a mortgage payment of roughly $1,796 per month. With the current mortgage rate of 7.09%, this would allow a borrower to qualify for a mortgage of approximately $265,000, which translates to a home purchase price of around $330,000 with a 20% down payment.

However, the median home price is far beyond this affordable range at $416,000. In order for a median-income household to qualify for a mortgage on a home of this price at current rates, they would need to earn $95,700 annually, which is 24% higher than the current median household income. This price disparity is causing many potential homebuyers to be priced out of the market.

The Consequences of Rising Mortgage Rates

The current state of housing affordability is not likely to be sustainable in the long run. Several possible scenarios could unfold, with significant consequences for the housing market and the broader economy:

1. Interest Rates Decrease: If mortgage rates were to drop to around 5%, the median-income family could once again afford a mortgage on the median-priced home. This would likely boost home sales and bring some relief to buyers.
2. Home Prices Decline: If housing prices were to fall by 21% to $330,000, the housing market could experience a correction. While this might make homes more affordable, it could also create a negative wealth effect, reducing consumer confidence and potentially slowing economic growth. A similar drop in home prices occurred during the housing crisis of the Great Recession.
3. Higher Down Payments: Another potential outcome is that buyers may need to make larger down payments in order to afford a home. However, for many, saving up for a 20% down payment is a significant challenge, particularly given rising living costs.
4. Smaller Homes or Different Locations: Buyers may lower their expectations and opt for smaller homes or properties in less expensive areas, as they try to stretch their budgets to accommodate higher mortgage rates.
5. Increased Income Demands: As housing becomes more expensive, many potential buyers may seek higher-paying jobs or ask their employers for raises. While this could temporarily improve affordability for some, it may also contribute to inflationary pressures in the economy.
6. Delaying Purchases: Most likely, many would-be homebuyers will choose to wait in the hopes that mortgage rates will decrease by 200 basis points. However, a significant drop in interest rates could coincide with an economic downturn, making consumers hesitant to take on new financial commitments.

Alternative Financing Options

For those unable to afford a fixed-rate mortgage, adjustable-rate mortgages (ARMs) may appear to be an alternative. Currently, 3/1 ARMs are priced at around 6.12%, which is still higher than what is affordable for the median household. While ARMs offer a lower initial rate, they come with the risk of higher payments when the rates adjust, which can make them an uncertain choice for many buyers.

The Bottom Line

As housing prices rise and mortgage rates remain high, the affordability of homes is becoming increasingly difficult for the average American household. The resulting effect is twofold: fewer people can afford to buy homes at current prices, and those who already own homes are less likely to sell, as they would have to take on a higher mortgage rate for a new property. This has led to a reduction in housing supply, further exacerbating the affordability crisis.

Looking ahead, the housing market could see slower growth or even a correction if rates decrease or prices fall. But until then, the market is likely to remain constrained, leaving many potential buyers on the sidelines, hoping for better conditions in the near future.