Home sales are down, down 20% from last year. Sharp declines occurred among people considering moving to a bigger, nicer or newer home. The simple arithmetic of door-to-door payments is behind this decline.
Imagine a family that owned a home and refinanced it in the summer of 2020, taking advantage of low mortgage rates. Let’s say they put 20% less on the house. Mortgage rates averaged 2.94% two years ago, making the monthly house payment about $1,039 for a median priced home of $310,400. (This will seem very low to residents of some cities, but it was actually the national median in August 2020.)
Two years have passed. The house has appreciated by 30%, around the national average. But even if the house is worth more, it is not bigger than before. Let’s say the family would like a bigger house, or a newer house, or a house in a better neighborhood. They think of a house that is worth 25% more than their current house. How much will it cost them to upgrade?
The family’s net worth has increased thanks to the rising value of their old home. Suppose they roll all their equity into a new mortgage. But the new mortgage rate is a huge problem. Leaving behind their old mortgage, they will pay 5.22% if their transaction is at the recent average (as of August 2022). Their monthly payments will increase by 85%. If they had started in the middle house, their payout would go from $1,039 to $1,922.
Most people won’t be willing to pay 85% more to get 25% more value. Certainly, some will hold their noses at the higher cost and move to another city to take a better job. Others really want that third bathroom or the best school district. For most people, however, the value proposition doesn’t work.
What economists call “diminishing marginal utility” further aggravates the decline in demand. The added benefit of going from two bathrooms to three bathrooms is less than the gain of going from one to two bathrooms. The third bath does not add as much value as the second. And the second didn’t add as much as going to an indoor bathroom versus an outbuilding. The same goes for bedrooms, total square footage, lot size, quality of appliances, etc.
Income gains can overcome the decrease in marginal utility. When people have a higher inflation-adjusted income, they spend it on something, and often that’s better housing. But right now, incomes aren’t growing as fast as consumer prices are rising, which is dampening demand for more expensive homes.
There will be a few people who actually go up, including some who have to move to another city for a job, and those who haven’t spent all their money and now want better digs. In some markets, prices may fall due to weak demand, allowing some people to move into a larger home for a lower cost increase. Typically, however, the real estate market will be weak for at least two years.
The only silver lining in this dark cloud is that it will show people – once again – that house prices don’t always go up.