Record Low Mortgage Rates Boost Affordability, But Mask Down Payment Difficulties

Photo: Getty Images Photo: Getty Images

Falling interest rates are the primary driver of improving mortgage affordability in recent years. Currently, the average rate on a 30-year, fixed-rate mortgage is 2.8%, according to Freddie Mac, almost 100 full basis points less than the 3.75% average rate quoted at the same time a year ago.

SEATTLE, Washington. November 17, 2020 (Zillow) — Ultra-low mortgage interest rates are helping to keep monthly payments remarkably affordable for would-be home buyers and homeowners alike. But these same low rates are also helping to mask an alarming rise in price-income ratios, keeping homes affordable on paper while doing nothing in practice to help buyers put themselves in position to buy in the first place.

A would-be home buyer earning the median income for buyers ($83,674) and looking to purchase the typical U.S. home in September — assuming a 20% down payment and 30-year, fixed-rate mortgage at prevailing rates — could expect to spend 17.5% of their monthly income on a mortgage payment, taxes and insurance. The same buyer could have expected to spend 18.2% and 19.6% of their income each month on their core housing payments in September 2019 and September 2018, respectively, according to a Zillow analysis of housing costs and projected income growth over the past two years.

At current rates, mortgage payments on the typical local home are most affordable in Louisville (12.3% of income), Birmingham (12.5%) and Indianapolis (12.7%). They are the most burdensome in San Francisco (34.4%), San Jose (31.6%) and Los Angeles (29.9%).

Rates at Historic Lows

Falling interest rates are the primary driver of improving mortgage affordability in recent years. Currently (as of Oct. 26, 2020), the average rate on a 30-year, fixed-rate mortgage is 2.8%, according to Freddie Mac, almost 100 full basis points less than the 3.75% average rate quoted at the same time a year ago. The other side of the affordability equation — incomes — are also improving.

In September 2020, typical U.S. homeowner incomes grew an estimated 2.7% relative to the prior year, from $81,502 to $83,674. At the same time, the typical total monthly payment fell 1.4% year-over-year — but almost entirely on the back of lower interest rates. Because even as incomes grew, home prices themselves were growing even faster. While homeowner income was up 2.7% year-over-year in September, the typical U.S. home increased in value by 5.8% over the same period.

Since September 2014, home values have grown 38.3%, roughly double the pace of homeowner income growth (18.8%) over the same period. It was not so long ago that a mortgage rate of 5% on a 30-year, fixed-rate loan was considered a steal — in weekly data from Freddie Mac going back to 1971 (which includes periods, like the early 1980s, in which rates in the teens were commonplace), the average rate on a 30-year, fixed-rate mortgage is 7.92%.

Historically low mortgage interest rates have been a fixture of the market for the past several years, hovering in the mid-4% range for much of 2018 and 2019. But rates below 3% were virtually unheard of prior to the past few months — but have been below 3% on average in every week since July 30.

Low rates are undoubtedly good news for would-be home buyers and particularly current homeowners, who have enjoyed big equity gains in recent years and can now refinance their mortgage to lower their monthly payments and save thousands of dollars over the course of their loan. But these low rates serve to mask an ugly truth: Without them, rapidly rising home prices and more-modest wage growth would threaten to put homeownership out of reach.

The Price of Rising Prices

For the better part of the last 6 years, total monthly payments grew faster than incomes. In September 2020, the U.S. home price-to-income ratio was 3.1 — meaning the typical home was worth 3.1 times as much as the typical homeowner earned in a year — the highest multiple since at least 2014. In January 2014, the typical home was worth about 2.6 times the median homeowner income. Since 2014, the long-run average price-income ratio has been 2.8.

When income growth fails to keep pace with home value growth, it makes saving for a suitable down payment of even 5% or 10% — to say nothing of the “standard” 20% down payment assumed in this analysis — that much more difficult. Putting 20% down enables buyers to avoid paying additional private mortgage insurance premiums, but it’s not required, and just 39% of buyers with a mortgage put down at least 20%, according to the 2020 Zillow Consumer Housing Trends Report.

And it’s no wonder: Saving for a down payment is a massive financial barrier for those looking to move into homeownership. More than a quarter of first-time buyers report difficulties saving for a down payment, and 40% of all buyers rely on a gift or loan from family or friends for at least part of their down payment, according to the same 2020 Zillow survey.

At the start of 2014, a 20% down payment on the typical U.S. home would have been about $36,600, or 6.4 months of income for the median homeowner household. As of September, that down payment had grown to about $52,000 (on a home worth almost $260,000) — or about 7.5 months of income for the typical homeowner household. Zillow expects the typical U.S. home to grow in value by 7% over the next 12 months, to slightly more than $278,000 by September 2021.

By then, the amount needed to cover a 20% down payment on that typical home will have risen to $55,600 — up about $3600 from today, or a full $300 in additional savings needed per month. Faced with this unrelenting rise in home prices, it’s no wonder that buyers currently in the market may be desperate to quickly settle on a home and lock in a low rate — savings that are adequate today may not be tomorrow.

Among the 50 largest U.S. metros, down payments are most in reach for potential buyers in Cleveland, where a 20% down payment on the typical home is equal to 5.1 months of income for the median homeowner household. Milwaukee, Pittsburgh and Memphis have the next most affordable homes by this measure, each at 5.2 months of income. Homes are most difficult to save for in high-priced California metros, led by San Francisco (17.1 months of income), San Jose (16.1), Los Angeles (14.9) and San Diego (13.2).

Mortgage interest rates are expected to stay low for the foreseeable future, but if and when they begin to rise again — even modestly — affordability and mobility may both deteriorate. There is the simple math that shows how even small rises in rates can impact monthly payments and ultimately limit buyers’ budgets in the face of high prices.

But there’s also the long-discussed but yet-to-materialize specter of so-called “mortgage rate lock-in,” in which existing homeowners that already have a very low mortgage interest rate may be unwilling or unable to move as rates rise.

Renters Hit Disproportionately Hard

Renters, of course, cannot take advantage of low mortgage interest rates and finance their purchase over decades. They must spend more of their monthly income on rent than their homeowning peers will spend on a mortgage — and more money spent on rent is less money saved for a down payment. Even so, the share of typical renter income devoted to the typical U.S. rent was 29.9% in September, the lowest share since 2014 and below the 30% threshold at which a household is considered “rent burdened.”

This improvement can be laid almost exclusively on assumed growth in renter incomes since 2018, which would certainly be welcome news in almost any month… Except in our current moment. We have not yet modeled the full impact of COVID-19 on renter incomes, but research shows that renters have been hit disproportionately hard by unemployment and the lack of comprehensive and lasting fiscal assistance.

Given this, it is likely that the current share of typical renters’ income devoted to paying their rent is much higher in the current environment. We are currently working to incorporate these effects into a supplemental model of renter incomes, and look forward to publishing the results soon.