Buyer purchasing power is a homebuyer’s ability to purchase property funded by mortgage money. The amount of mortgage funds a homebuyer can borrow is based on:
- the homebuyer’s income, which usually adjusts annually at the rate of inflation; and
- current mortgage rates, which change constantly.
As mortgage rates rise, the interest portion of monthly payments on new mortgages increases. The result is a reduction in the portion of each payment which goes toward amortizing the mortgage principal. Thus, the maximum price a homebuyer can pay (their purchasing power) declines with rising mortgage rates.
The opposite is true of falling mortgage rates. When mortgage rates decline, buyer purchasing power increases. The past 30 years was a period of declining mortgage rates, which brought about increased borrowing capacity without the need for an increase in pay. [More on historical trends of buyer purchasing power on Card 5]
Further, little adjustments in mortgage rates significantly affect buyer purchasing power. Consider an average homebuyer whose gross annual income is $60,190. This allows them to make monthly payments (at 31% of their gross income) of $1,555.
The $1,555 monthly payment qualifies them for the following mortgage amounts on a 30-year fixed-rate mortgage (FRM) at different rates:
|Mortgage rate||Mortgage amount|
If the mortgage rate fluctuates by so much as half a percentage point, the mortgage amount changes by tens of thousands of dollars. As a result, when mortgage rates rise, a homebuyer’s income qualifies them for less principal, causing them to become disenchanted and exit the market. Their only other option is to settle for less house than they were able to qualify for at the old mortgage rate, as sellers are slow to drop their price expectations when mortgage rates rise.
Buyer purchasing power is the driving force behind real estate pricing, as each homebuyer in need of a mortgage has a maximum price they qualify to pay to purchase property. This maximum price depends on:
- the buyer’s down payment; and
- the mortgage funds they qualify to borrow from a lender.
When buyer purchasing power falls, home prices are sure to follow. When purchasing power rises, the outlook for future price increases is good.
History tells us that home prices begin to rise about six months after buyer purchasing power rises. Home prices begin to fall 9-12 months after buyer purchasing power begins to fall in a sustained manner. The delay for falling home prices is due to the sticky price phenomenon, in which sellers initially refuse to adjust their prices to reflect today’s fair market value (FMV).
Other factors that influence these pricing trends include:
- speculator over-activity (as in 2012-2013), which artificially boosts home prices even when buyer purchasing power declines;
- adjustable rate mortgage (ARM) usage, which provides additional funding and temporarily delays decreases in pricing due to depressed buyer purchasing power;
- the personal savings rate, which addresses down payment amounts and thus mortgage insurance;
- construction and zoning, which tempers home pricing in desirable areas;
- population density and income growth, which influences home sales volume and price movement; and
- economic shocks, which cause end user homebuyers to exit the market and investors to swoop in.
The annual difference in buyer purchasing power (and first tuesday’s Buyer Purchasing Power Index, or BPPI) is calculated this way:
1. Calculate the annual income of your average homebuyer. For our purposes, we use California’s median household income as of 2013 (those most recently reported Census year) — $60,190. With this annual income, a homebuyer’s maximum monthly payment at 31% of their gross income is $1,555.
2. Use this monthly payment and today’s average mortgage rate to determine how much principal a homebuyer with an average income is qualified to borrow. For example, at a mortgage rate of 4%, our average homebuyer qualifies for a mortgage principal of roughly $325,800.
3. Compare this with the mortgage rate a year earlier. For instance, if a year earlier the mortgage rate was 3.5%, this same homebuyer would have qualified for a mortgage of $346,300.
Thus, their purchasing power has been reduced by $20,500, or 5.9%. In this example, the general reduction in average buyer purchasing power signals a decrease in pricing on the horizon.
Mortgage rates last peaked in 1982 at an average rate of 17% on a 30-year FRM. These rates generally declined for the next 30 years, bottoming in 2012 at just over 3.3%. At this time, the interest rate on the 10-year Treasury note (which lenders use to set their mortgage rates) was near zero. The last time it was this low was just after World War II, which ended the Great Depression and a prior interest rate cycle — roughly 30 years up and 30 years down.
We are now in the upswing of the cycle, as interest rates on Treasury notes and mortgages are expected to rise for the next two to three decades. Further, as in the period of rising mortgage rates from 1949-1982, prices will feel downward pressure due to the decrease in buyer purchasing power — unless wages increase to offset increasing mortgage rate results. In a very broad sense, price increases over the next few decades will be limited to the rate of consumer inflation, around 2%-3% a year.
Of course, prices will fluctuate above and below the inflation rate from year to year based on changes in local demographics, jobs, zoning and construction.
For charts displaying the historical trends of buyer purchasing power and the connection between this and mortgage rates, see: Mortgage rates drive buyer purchasing power.
Read more about the connection between buyer purchasing power and home prices at: The source of home price movement: buyer purchasing power.
For more on the sticky price phenomenon, see: Sticky prices, tricky situation.
Read more about the 60-year interest rate cycle at: 30 years of summer followed by 30 years of winter.