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What I am about to share with you is an excerpt from a fall letter I wrote to IMA clients. It is long; therefore, I’ve divided it into two sections. Today I’ll discuss the (sorry) state of the housing market; tomorrow, I’ll discuss the economy.

The housing market is worse than you think

In this letter I’d like to explore the impact interest rates will have on the economy and especially the housing market.

Currently, the 30-year mortgage rate is pushing 7.6%, up from less than 3% a year ago, while the median house price in the US is up 37% from $320k in 2019 to $440k today. You cannot have both interest rates and housing prices making new highs. Something’s got to give.

Let’s start with new home buyers, as they’ll be impacted the most.

If you are a first-time home buyer, you don’t have home equity to roll into a new purchase. If you bought a house in 2019 for $320k (assuming you put down 20% of the purchase price as down payment), your annual mortgage payment at 4% would have been $15k.

Two years later, in 2021, you would have paid $420k for the same four walls and white picket fence (dogs, spouse and 2.5 kids sold separately). However, despite a 37% house price increase, thanks to Uncle Fed, you would have been able to finance this purchase at 3%, and your annual mortgage payment would have gone up to $17k – a manageable $2k annual increase.

As I have mentioned, today the median house price is at $440,000, but the interest rate has skyrocketed to 7.6%. Thus, if you are a first-time home buyer, the same American dream would cost you $30k a year – that is a $13k increase from just a year ago.

Let me put this in proper context – median annual household income in the US is about $75k, or about $60k after taxes. In other words, half your after-tax income is now going to servicing your mortgage if you bought today at peak home prices and rates.

It is easy to see how the combination of high prices and rising interest rates have turned the American dream of owning a home into a nightmare. For affordability to come back to 2020 at current interest rates, housing prices have to decline more than 40% to $250k. If this were to happen, anyone who bought a house since 2012 would be underwater on their initial purchase.

It is hard to envision this rapid price decline happening overnight. Just like stock prices, housing prices are set by supply and demand. But houses are not like stocks. People live in their houses, raise their kids there, create memories, and thus get emotionally attached to them. Also, many decades of declining interest rates and rising housing prices have convinced the public that increasing housing prices must be guaranteed by the US Constitution in tandem with the right to the pursuit of happiness.

When we decide to sell our house and we receive offers that are below the highest price we saw on Zillow just a few months earlier, we wait for the right, higher offer to come in. This is why the fact that we live in our houses is important – we are emotionally attached to them and want the best offer possible. This is also why housing prices are quick to move up and slow to come down. It takes multiple painful conversations with a realtor to convince us to start lowering the asking price.