HOME EQUITY STUNNER
We’ve followed the graph below—home price appreciation (as measured by the Loan Performance home price index) vs. the percentage equity in the average American homeowners’ house—for some time, always marveling at how during the recent period of tremendous home price appreciation (thanks to low rates, abundant credit and easy underwriting standards), home equity in residential real estate actually fell and then plummeted in the first decade of the 21st century. This process started well before home prices peaked in the summer of 2006—we chalk it up to the simultaneous wave of home equity extraction that occurred with the help of the refinancing mechanism—and accelerated once the market tanked.
This leaves the country in an uncomfortable position. As it currently stands, the average homeowner has about 38% in home equity in his or her house, down from the 60% to 70% range up until the 1990s. In other words, the average loan-to-value of the average house in the US has risen to about 62% today. (This is an average; backing out the approximately 1/3 of homeowners with no mortgage at all likely makes the average among those with a mortgage somewhere around 85% loan-to-value. But we digress.) An important feature of homeownership has been its historic role as a savings and wealth building engine as mortgage principal amortizes and home prices drift upwards. This has been turned on its head with the collapse in housing values and the residual effect of home equity extraction. Leaving aside for the moment the miniscule savings rate in the US, how does this expose the average American to interest rate risk?
The answer is….it exposes them more at today’s low levels of nominal interest rates and home equity. A friend passed along the idea that spawned this answer. In a nutshell, what we have done is start with the Federal Reserve data on real estate values and home equity as a percentage of real estate market values (from the indispensable quarterly flow of funds report). Then we assume that the average 30-year mortgage rate is 1% (100 basis points) and 2% (200 basis points) higher. We present value the change in the cash flow stream from higher monthly mortgage payments and deduct it from real estate values, and then subtract debt outstanding to come up with a change in nominal homeowners’ equity. The graph below shows that if mortgage rates were 100 basis points or 200 basis points higher, real estate values would decline, but the change would vary depending on the nominal level of rates. At current rates, the value of homeowners’ equity would decline by 19% and 39%, respectively, much deeper declines than would have obtained in the 1980s and 1990s.
We then take the new value for homeowners’ equity and divide by the new real estate values and come up with new numbers for the average homeowners’ equity percentage. Currently, if rates were 100 basis points and 200 basis points higher, the average US homeowners’ equity would decline to 31% and 23%, respectively.
This exercise tries to quantify the intuitive observation that if mortgage rates were to increase home values would decline, which in turn would reduce the amount of equity the average homeowner has in his or her home, all other things being equal. Policymakers debating financial regulatory reform and the future of mortgage finance in America, please take note: Instituting reforms that result in higher mortgage rates will hurt the average homeowner more today than it would have 20 or 30 years ago.
Do you guys see the Loan Performance home price index as a leading indicator of future price adjustments in the real estate market? In other words, looking at the historical trend, is it possible to predict a future period of price ajustment up or down?
Am i understanding this correctly in that you are assuming all mortgages are on an adjustable basis?
tpc – YOU SAY APPROXIMATELY 1/3 OF HOMEOWNERS HAVE NO MORTGAGE – THAT NUMBER IS FALSE.
I’VE SPENT A LOT OF TIME TRYING TO UNDERSTAND THE CENSUS NUMBERS OVER THE YEARS AND IF YOU LOOK AT OWNER OCCUPIED NUMBERS, THOSE WITHOUT A MORTGAGE ARE AROUND 15%.
ALSO, IF YOU INCLUDE THE NUMBER OF HOUSEHOLDS YOU GET A NUMBER OF LESS THAN 20% OF ALL AMERICAN HOUSEHOLDS EVER OWN A HOME FREE AND CLEAR. OF THAT 20% OR SO, MANY WILL USE SOME OR ALL OF THEIR EQUITY IN RETIREMENT (SUCH AS IN A REVERSE MORTGAGE).
THE MYTH OF HOME “OWNERSHIP” IN AMERICA NEEDS TO BE REVISITED. MOST PEOPLE RENT HOMES FROM THE BANK.
MORTGAGE MEANS TILL DEATH!
peace – SCOTT
I suppose it could be 15% or 30% depending on whether you are counting married couples as 2 or 1, since the majority of homeowners are married. Some people also have more than one house, and professional landords usually have many. The correct measure is what fraction of housing units are owned free and clear, regardless of whether the owner lives in the building.
the correct number is the number of houses owned free and clear as a percentage of ALL households.
this is the only way to get a real ownership figure, not the phoney “of all homeowners” number.
my point is that only a small fraction of americans will ever really own a home and yet that is “the american dream” that is shoved in their faces by the MSM every day…(although not so much these days!)
Peace – scott
The home equity trends make sense if look at the trend of long term interest rates over time. Treasury interest rates (Treasury and Fed Reserve web sites have data you can plot) steadily rose from the Depression through the 1970s, had sharp peaks around 1979-1981, and then trended steadily downward for 30 years at about 0.23% per year. While there are lots of short term variations in rates, and gaps in the data pre-WW2, the long term trends are very clear if you plot the data over an 80 year time scale. As interest rates decline, the cost of servicing debt declines also, and thus people can take on more debt – and do so. In the 2000s with the real estate bubble, we saw that process finally reach its limit. Home equity will continue to fall until house values start rising again.
So, what is the long term outlook for interest rates? Short rates are a low as they can go, and long rates have little room to go down (although it could still take another decade to bring 10-yr rates to zero if the post-Carter trendline holds up). At some point rates have to start going up again unless the Government finds a way to institute and enforce nominal negative rates. However, sideways movement is also possible, as in Japan over the last 2 decades.
So how does one make money off this? I really don’t know because the hardest thing to learn from plotting historical data is the timing of the turning points. Turning points are generally crisis driven, and can be very sudden.
silly central bank illusion and you are it’s captive!