Why Housing Affordability Is at Risk

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Homes are more affordable now than they have been in decades, but that could turn more quickly than expected, because the affordability is based entirely on mortgage rates.

Home prices are actually rising faster than expected, but the gains are being masked for buyers by historically low rates. These rates allowed U.S. homeowners to pay almost 37 percent less in monthly mortgage payments at the end of last year than pre-housing–bubble norms, according to a new report from online real estate portal, Zillow. This as homes today cost 14.5 percent more compared to historic averages, relative to median incomes.

The average rate on the 30-year fixed mortgage dropped to 3.68 percent last week, according to the Mortgage Bankers Association. From 1985 through 1999, rates ranged from 6 to 13 percent. Present low rates have allowed buyers to purchase more expensive homes, and the mortgage payment is taking less out of their monthly paychecks.

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Back in the mid-eighties and nineties, Americans spent nearly 20 percent of their median monthly incomes on their home loans—compared to just 12.5 percent today, according to Zillow.

The trouble is that wages have either stagnated or dropped at the same time that home values are rising. Pre-bubble, U.S. homebuyers spent 2.6 times their median annual incomes on the purchase price of a typical home, but now they are spending three times their incomes—meaning homes are 14.5 percent more expensive relative to income, according to Zillow. That is all made possible by government-subsidized, record low rates.

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"The days of historically high levels of housing affordability are numbered," said Zillow Chief Economist Stan Humphries. "Current affordability is almost entirely dependent on low interest rates, and there's no doubt that rates will begin to rise in the next few years."

Rates will rise because the Federal Reserve will inevitably have to get out of the business of buying agency mortgage-backed securities, which currently drives down rates. This won't happen immediately, but it will in the next two to three years.

That will directly affect home buying demand, because without dramatic income growth, potential first-time buyers will see monthly payments as too big of a chunk to pay. Meanwhile potential move-up buyers will not want to let go of their fixed low rates, and that will be a disincentive to move.

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Homeowners in 24 of the 30 largest metros covered by Zillow were paying more for homes at the end of 2012 relative to their region's median income than they were from 1985 through 1999. That is a clear red flag that should rates rise, even a few percentage points, home purchases and purchasing power, will fall.

—By CNBC's Diana Olick; Follow her on Twitter @Diana_Olick or on Facebook at facebook.com/DianaOlickCNBC

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