Why is Housing so Expensive? This is a question that a lot of young people have. In this post, we analyze the main reason why homes have become so expensive over the last few decades and how to fix it.
- Types of Home Buyers
- Drawbacks of Investing in Real Estate
- Real Estate Prices and Interest Rates
- Why were Interest Rates so Low?
There are many variables that determine the price of a home: size, quality standards, number of bathrooms, location, etc. As a result of that, it is expected that larger homes in nice neighborhoods are more expensive than small apartments in less desirable locations.
However, what we will focus on in this post is why housing, in general, has become so expensive and unaffordable in many places. This is a problem affecting a large portion of the population, especially young people.
If we listen to politicians, they will either tell us secondary reasons for this problem, like not enough houses are being built to meet housing demand, or even outright lies, blaming it on speculators or, worse yet, capitalism.
However, it is governments and public institutions that are the main reason for the high cost of housing.
Homes are so expensive because interest rates have been very low for decades. And interest rates are mostly set by governments and public institutions such as central banks. Higher interest rates lead to lower home prices. Lower interest rates lead to higher home prices.
Let us analyze the relationship between interest rates and the price of housing by looking at two different types of home buyers:
Types of Home Buyers
In general, there are two types of home buyers: those who buy a mortgage and those who pay cash for a home. Though it may seem unintuitive, both types of home buyers are affected by interest rates:
Buyer with Mortgage
A mortgage is a loan that allows us to finance the purchase of a home over a long period of time, often a few decades. To find out if we can afford the monthly mortgage payments, we will compare those payments with our salary.
The mortgage payment depends on three variables: the term of the mortgage, the amount we borrow, and the interest rate.
The term of the mortgage tends to be quite standard and, in many countries, purchases are financed over a period of 30 years. The amount we borrow and the interest rate are closely related. The lower the interest rate, the more we can borrow and pay for a home, and vice versa.
To understand the impact of higher or lower interest rates on home prices, we will fix the term of the mortgage at 30 years and the monthly mortgage payments that a household can afford at $1,500. The table below indicates how much money a family can borrow, based on different mortgage rates, to pay back the debt over 30 years with a monthly payment of $1,500.
We also assume a down payment of 20% to see the direct relationship between the interest rate and the house price:
As you can see, the lower the interest rate, the more money can be borrowed. And that will lead to higher home prices.
Buyer without Mortgage
Home buyers who do not need a mortgage are people with enough money to pay for the house in cash. Because house prices have risen so much over the past few decades, there are fewer and fewer buyers who do not require a mortgage.
Most cash buyers are investors who prefer to put their savings in a house and rent it out rather than have the money in the bank. And we need to understand why motivates an individual to buy a home rather than keep their money in the bank. Investing in real estate has some drawbacks relative to other types of investments.
Drawbacks of Investing in Real Estate
- Transactions costs: when we buy a home, we have to pay taxes and plenty of closing costs. In some countries, especially in Europe and Asia, real estate transactions costs can be substantial. Other types of investments or keeping money in the bank does not carry any of those transaction costs.
- Property management: owning and managing rental properties takes time and effort. Unless we delegate those tasks, property management cannot be considered passive. Financial investments are a lot more convenient from that perspective.
- Lack of liquidity: real estate is a very illiquid asset. If we need money and want to sell a property, it will take time and money to do it. In many jurisdictions, taxes will have to be paid.
Real Estate Prices and Interest Rates
As you can see, the relationship between low interest rates and high house prices is obvious. The reason why housing has proved such a great investment since the 1980s is because the four decades that followed the high interest rates of the 1970s and early 1980s were dominated by ever lower interest rates.
That meant that prices were constantly repriced higher. As a result, subsequent generations always had to pay higher prices. Even though mortgage monthly payments remained relatively stable, the appreciation in the housing market accrued to older generations, widening the intergenerational wealth gap and making it more difficult for younger generation to get on the housing ladder.
Consequently, a proper understanding as to why housing is so expensive requires a lot at the trend in interest rates and the reasons why interest rates have gone down so much.
Why were Interest Rates so Low?
Although interest rates are partially determined by the supply and demand for money, they are mostly set by as central banks who acts as monetary authorities. Central banks act as government agencies.
Therefore, even though they are supposed to be independent from the government, they act in the interest of the government in most cases.
Because governments have borrowed so much money over the last few decades, they have accumulated large debt piles. The only way governments would be able to pay interest on that debt without defaulting is by making sure that interest rates remained low or moved constantly lower.
The last four decades have been marked by growing public debts and ever falling interest rates. One of the unexpected consequences of this budget and monetary policy has been higher housing prices that have priced most young people out of the market.
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