My 1st Million At 33 - yes, you can do it too

Assuming that the amount of affordable mortgage payment is fixed, how much housing market will fall because of the increase in mortgage rate?  Actually, if you look at the other side of coin, the equivalent question is how much the mortgage payment will increase if the housing price stays at today’s price?  While I don’t exactly know which way the housing market will play out, I tend to think that the first question makes more sense simply because the amount of salary dedicated to house payments has been over-stretched.  The probability of further affordability stretch should be low going forward.

Here are my calculations for how much housing will fall, assuming various loan scenarios (starting from the most conservative to the most aggressive):

1. 30-year conforming loan: If I use 5.25% 30-year mortgage from about last summer (for conventional & conforming loan under $417K), and a current 6.25% 30-year mortgage. The affordable loan size has shrunk by 10.3% already. Even if I assume that a standard 20% down payment from last year by the potential buyers is still available, the affordable housing price would still shrink to 20% + 80% * (1 - 10.3%) = 91.8% of the last year housing price. That means the housing price must fall by (100%-91.8%) = 8.2% assuming the same affordability.
2. 1-year ARM: If I use 4.15% 1-year ARM, and 5.68% 1-year ARM, affordable loan size shrinks to 84% of the original. Assuming only 10% down payment is still available, the housing price should fall to 10% + 90% * 84% = 85.6%, or fall by 14.4%.
3. Option ARM: If I use an interest margin of 2.5%, and MTA index of 2.17% for Feb 2005 and 4.28% for May 2006, and assume the choice of interest-only payment, the affordable loan size shrinks to 69% of the original. Assuming only 5% down payment is still available, the housing price should fall to 5% + 95% * 69% = 70.6%, or fall by 29.4%.

The following table is to illustrate the effect of interest rate on payment and loan size.  The 30-year amortized payment is based upon a loan size of $400K.  Both of loan sizes for 30-year and interest-only are based upon a fixed payment of $2500.

The above analysis is a glass half-empty viewpoint. If one did similar analysis but with a half-full viewpoint, one will probably be able to justify a 30% to 50% rise in the housing price back in 2002 using Option ARM.

By the way, if you want to adjust for a total salary increase of 5% before tax, or a 3% increase after tax, you should multiply the affordable loan size by 1.03 factor to account for any increase in the salary.

Most of the historical data on mortgage interest rate came from Mortgage-X.  I use this site every time when I want to do such analysis.