Is the Forecast for a Crash in the Housing Market?

As anyone who has owned a house for a couple of decades can attest, home values have been rising steadily for quite some time. In some localities with booming economies, home values have risen much more quickly than the national average.

Real estate represents the largest household asset in the country. In the third quarter of 2004, Americans owned $16.6 trillion in real estate, up $2.2 trillion over the same quarter in 2003, a 15.4 percent increase in just one year. A downturn in housing prices could be very damaging to the economy.

By comparison, when stock market prices fell dramatically, the impact was far-reaching and served to prolong the economic recession. However, Americans owned $9.4 trillion in equities and mutual funds, significantly less than the amount of real estate they owned. With real estate being such a large percentage of household assets, the price is obviously very important to each individual homeowner, as well as to the economy as a whole.

Home prices rose 13 percent just in the past year, with prices going up much more in some regions. In Nevada, for example, prices went up 36 percent in 2003 over 2002. Home prices are at an all-time high, and monthly payments now represent 18.32 percent of after-tax income, 41 basis points away from the record high, and 131 basis points above the long-term average.

Clearly, homes are more expensive, and are affordable now only because of low interest rates. What will happen to home values when the interest rates go back up?

Some economists have expressed concern about what effect raising interest rates would have on housing prices. The low current mortgage rate and easy credit have made it easier than ever to buy a home, which has resulted in a housing bubble that some fear is not sustainable. When interest rates rise again, demand will go back down, and some worry that the high values that homes have achieved will not last.

The Federal Reserve Board however, advises that housing prices are rising worldwide, and not just in the US; and notes that from a historical perspective, when interest rates rise, as they inevitably will again, housing prices seldom see a real drop; instead, they just increase at a slower pace. There appears to be a continuing need for new home construction.

The Fed acknowledges that rising rates are likely to lead to an eventual decline in sales, however, the economic impact of a home sales downturn would be offset by an upturn in other business activity, so even with all things considered, the impact would be very limited in scope.