How Much Does a House Cost?

What a simple question! Houses are listed for sale with the prices clearly stated. You make a bid, usually 10% below the list price. If it's accepted and validated by an appraisal, the price is set. On Wall Street, the agreement of a willing buyer and a willing seller is called "price discovery." Let's assume that, through this price discovery process, we have determined that the cost of the house pictured above is $250,000 and we want to buy it.

But there's a problem. Our house, like many others, costs $250,000, but we, like most ordinary Americans, do not have $250,000. We cannot pay the cost of our house from our own pocket. We can, however, pay monthly mortgage payments of principal and interest. Now, it might seem that the price of our house determines the amount of our mortgage, which in turn determines our monthly payment. That's how the math works, but the fundamental economic dynamic is exactly the other way around: Our monthly payment, which is what we actually pay and can afford, determines the amount of our mortgage, which in turn determines the price of our house. This commentary explores how and why this is so.

The median annual household income in the United States is about $50,000. It's a rule of good personal financial management that the cost of shelter should be no more than one-third of gross income. For a family at the median income, that's about $1,400 a month, of which about $1,100 would be for the mortgage, with the rest going to real estate taxes and insurance. As it happens, $1,100 is just about the monthly mortgage payment for a $250,000 house under current conditions. So, while we, like most people, can't pay $250,000, we, like most people, can pay $1,100. The result is that many houses can cost $250,000…under current conditions.

The most important current conditions are our required down payment, our mortgage's interest rate, and its term. We can buy our house with a down payment of $8,750, at an interest rate of 3.5%, and for a term of 30 years.

Mortgage conditions were very different during the Great Housing Bubble. Back in 2006, if we could afford a monthly mortgage payment of $1,100, we could buy a house with an appraised value of $660,000 or even more. Here's how it was done. In our imaginary mortgage's first year we only had to pay interest, not principal, and the rate was set artificially low. A rate of 2% or less was typical. Twelve monthly payments of $1,100 is $13,200, which is 2% of $660,000. It was in everyone's interest—the seller, the real estate agent, the mortgage broker—that our house cost as much as possible. We, the buyer didn't mind either, because after the first year we were sure we could refinance… or the house's market value would increase… or something.

That's how, within a few years, the cost of our house could vary by more than $400,000. But that's not nearly the whole story. In fact, now is when things get interesting. Why would anyone grant an ordinary American household a 30-year loan equivalent to five times our annual income? Think of all the vicissitudes of life that are likely to affect us over three decades! A sensible lender might be willing to make us a loan with a term of five to seven years. Lots of bad things can happen in seven years, but at least we will be reducing the principal balance of our loan quickly. This will give the lender more value in its collateral and thus a greater sense of security. Again, let's suppose we can afford a monthly mortgage payment of $1,100. Assuming the same interest rate and down payment, but a seven-year term, the cost of our house would be $85,000.

So what does our house cost? Is the answer $660,000, $250,000, or $85,000? The right answer is $250,000 because the federal government makes it so.

The Federal Housing Administration (FHA), a division of the Department of Housing and Urban Development (HUD), is the largest mortgage insurer in the world. For a fee paid by the mortgagee, FHA agrees to pay lenders in the event of a homeowner's default. Mortgage loans insured by FHA are pooled and readily sold to investors worldwide in huge amounts because the timely payment of principal and interest is guaranteed by the US Treasury. Many other US mortgages are pooled and sold under similar protection by Fannie Mae and Freddie Mac. These companies are also part of the federal apparatus.

In this discussion of the cost of our house, I have assumed that the mortgage we need to buy it will be insured by the FHA. I noted that we needed a down payment of $8,750 to buy our $250,000, because 3.5% of the principal balance is all that FHA requires. Similarly, the mortgage's low interest rate and 30-year term are possible only because, effectively, we are not the borrower. If we fail to pay our mortgage, the federal government will step in and make the lender whole.

The numbers produced by the major federal housing finance companies are truly staggering. FHA claims to have insured 40 million properties since it was created by Congress in 1934. In the last three years alone, Fannie Mae has provided $2.6 trillion in liquidity to the mortgage markets and helped borrowers to refinance 7.4 million mortgages and purchase 2.1 million homes.

And there's more. The biggest buyer of mortgage pools guaranteed by various federal government agencies is the Federal Reserve. At the end of last week, the Fed held $884 billion of mortgage-backed securities on its balance sheet, as part of its Quantitative Easing program. The Fed is buying $40 billion of new mortgage backed securities every month and reinvesting existing mortgages as they roll off.

And more and more. We can deduct the interest we pay on our mortgage from our federal tax obligations. We can deduct our real estate taxes too. And if we need a second mortgage to pay for home repairs, we can also deduct the interest on that loan.

To sum up, our house costs $250,000 because we can afford a mortgage payment of $1,100 a month. Our $1,100 monthly payment is made possible because the FHA is willing to insure our 30-year, 3.50% mortgage, which the Federal Reserve is willing to buy because it is as part of a federally-guaranteed pool of mortgages.

Some might complain that it's all a giant scam perpetrated on taxpayers, but it's not, for an extremely good reason. The people who pay taxes and the people who own homes with mortgages are one and the same. In fact, many of those people make their living in some aspect of the housing or related industries: construction, finance, appliance sales and service, furniture-making, and on and on. Housing is a giant job-creating machine made possible for massive federal government support and subsidy. The government's role is so big and multi-faceted, and we have taken it for granted for so long, that we hardly notice it any more. And we can't even begin to imagine what life would be like without it.

 

 

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