Think Home Prices Are Set to Drop? Don't Be So Sure

Homeownership has become less affordable, and many experts believe relief is near -- but this is far from certain.

Home prices have increased by more than 20% in the U.S. housing market over the past year, and mortgage rates have roughly doubled. This combination has made homeownership far less affordable for millions of Americans, and many are likely to be priced out of the market.

Now, it may seem logical that fewer buyers will cause home prices to fall, but don't be so sure. There are two sides to home pricing dynamics, and both are likely to be affected. And this could mean that much-needed price relief might not be on the way just yet.

Homes have certainly become less affordable

Home prices have risen at a rapid pace in 2021 and 2022. In fact, according to the S&P CoreLogic Case-Shiller Index, home prices increased by 20.4% in April 2022 (the most recent data available) compared with April 2021.

Not only have prices increased, but mortgage rates have spiked as well. The average rate on a 30-year fixed-rate mortgage was just under 3% a year ago but sits at 5.81% as of this writing.

Here's what this means to buyers. Let's say that a year ago you wanted to buy a home for $300,000. Assuming a 20% down payment, you could expect to pay about $1,005 in principal and interest (P+I) per month towards a 30-year mortgage.

Fast-forward to today. The same home would cost $361,200 based on the average U.S. home price increase. Your 20% down payment would be $72,240, not the $60,000 you would have to come up with a year ago. And the P+I portion of your monthly mortgage payment would be $1,697 -- nearly 70% more than it would have been a year ago. To say that homeownership has become less affordable is an understatement.

The real estate market is showing signs of slowing

As you might expect, given the declining affordability of homeownership, rising inflation, and the growing likelihood of a recession, the recent data shows that would-be home buyers may be moving to the sidelines.

According to the National Association of Realtors, existing home sales declined by 3.4% in May to the lowest level since June 2020, when COVID-19 restrictions were heavily impacting the market. New home sales are declining rapidly as well and are at the slowest rate since the start of the pandemic.

Low supply could keep prices high

Despite the clear slowdown in the housing market on the buyer's side of the equation, keep in mind that like any other market, real estate is largely governed by supply and demand dynamics. And there's reason to believe that supply could stay depressed for some time, and for the same reasons buyers are starting to stay on the sidelines.

Think about it this way. Let's say that you own a home that is worth considerably more than what you paid for it a few years ago and you'd like to upgrade. However, you got a mortgage with an interest rate of less than 3%, but if you sell and buy a new home, you'll have to get a new loan with a rate in the 6% ballpark. So, it's not just a question of being able to come up with the down payment for a trade-up home -- it's a question of being able to afford the monthly payments. Simply put, many existing homeowners don't want to give up the generationally low mortgage rates they have.

Based on the most recent data, existing home inventories had been on the rise from February through May, although this is somewhat due to seasonality and inventory is still lower than it was a year ago. Plus, keep in mind that COVID-19 restrictions were still impacting the market somewhat at this point last year.

It's also important to point out that the bulk of the recent rise in mortgage rates has occurred in the past month or so, and it will be some time before we see how it affects the numbers. According to National Association of Realtors chief economist Lawrence Yun, "the impact of higher mortgage rates are not yet fully reflected in the data." Just as we're seeing buyers move to the sidelines as rates rise, it wouldn't be surprising to see sellers do the same.