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JULY 2005

Chicago Fed Letter
Explaining recent changes in home prices
by Richard Rosen, senior economist and economic advisor

The increase in housing prices in the past ten years can largely be explained by falling
mortgage interest rates and changes in household income. This article offers some
projections of what might happen to housing prices if mortgage rates increase.

The median price for a single-family
home has increased at an accelerating
pace in the past ten years, after a period
of moderate price increases in the ten
years prior to that (see figure 1). From
1985 to 1994, prices rose at a real rate of
about 1% per year. The rate of increase
rose to 3.9% per year
during 1995–2004,
1. Housing prices and CPI-OER index, 1985–2004
with a significantly
higher annual rate of
median house price
4.9% in the second
(thousands of 2004$)
half of that ten-year
period. Some believe
that the rapid increase
in housing prices is a
House prices
sign of a bubble.1 In
this Chicago Fed Letter,
I document changes
in the median sale
price of a house in
the United States and
for major markets in
the Seventh Federal
Reserve District.2 I
show that the increase
in housing prices in
SOURCES: National Association of Realtors and U.S. Department of Labor,
Bureau of Labor Statistics.
most areas, including
the Seventh District,
can be largely explained by falling mortgage interest
rates and changes in household income. I also offer some projections of
what might happen to housing prices
if mortgage rates increase.

The median sale price of an existing U.S.
single-family house was $187,467 at
the end of 2004. This compares with

$112,619 at the end of 1984 and $126,076
at the end of 1994 (all figures are in
2004 dollars). To put the price increases
over time into context, I compare them
with a proxy for the earnings power of
housing stock. I then account for changes in personal income and mortgage
interest rates.
An owner-occupied house combines a
flow of services with an investment good.
The homeowner gets to live in the house
in lieu of renting and gets a potential
return on the equity in the house. In a
stable market, the return on home equity
should parallel that of other investments
with a similar risk profile. To split the
change in housing prices into the rental
equivalent portion and the return on
equity portion, I use the owners’ equivalent rent component of the Consumer
Price Index (CPI-OER) as a proxy for
rental income.3 The ratio of the median
sale price of an existing single-family
home to CPI-OER gives a picture of
home buyers’ expectations of price appreciation on their purchases. This is,
in essence, a price to earnings ratio.4
House prices rising much faster than the
stream of rental income could be a sign
that a bubble is forming.
As figure 1 shows, housing prices and
the rental index moved together until
the late 1990s. At that point, the rate
of increase in housing prices exceeded the change in the rent index. Some
have taken this as an indication of an
overheated market.5

2. Mortgage-servicing index and mortgage rates, 1985–2004

Mortgage-servicing index

Index using average
LTV ratio

Mortgage rates











LTV means loan to value.

SOURCES: Author’s calculations based on data from National Association of
Realtors; U.S. Department of Commerce, Bureau of Economic Analysis; and
Federal Home Loan Mortgage Corporation.

3. Simulated change in housing prices, one year ahead
rate (%)




Mortgage-servicing index



NOTE : The mortgage-servicing index is the ratio of the payment on a 30-year fixed rate
mortgage to nominal income, where the amount borrowed is 80% of the purchase price
of a home. This table assumes that nominal income is at 105% of its 2004 level. In 2004,
the average mortgage rate was 5.8%, and the mortgage-servicing index was 15.8%.
As of February 2005, the Blue Chip forecast of mortgage rates for 2005:Q4 had a
mean of 6.5%, with a minimum of 5.9% and a maximum of 7.6%.

pay the mortgage on
a house with the median sale price. This
compares with ratios
over 20% in the mid1980s and at least 18%
prior to 1990. Since
the mortgage-servicing
index has been relatively steady over the
last decade, the runup in housing prices,
especially in the last
five years, may be in
large part an artifact
of low interest rates.
A potential criticism
of this measure of
housing affordability
is that it assumes that
down payments have
not changed over time.
However, the findings
are qualitatively similar using the actual average down payment
rather than 20% to estimate the mortgageservicing index (dashed
line in figure 2).
What happens when
interest rates

An open question now
that interest rates are
trending up again is
how housing prices
will respond to the rate increases. The
best evidence we have from the recent
past is the 1994 increases in interest rates.
Mortgage rates rose from 7.3% in 1993 to
8.5% in 1994, leading the mortgage-servicing index to increase from 14.9% in
1993 to 17.0% in 1994. While the higher
index values signaled that housing was
less affordable in 1994 than in 1993,
this quickly reversed, with affordability
increasing in 1995 as the index declined
to 15.4%. The index remained roughly
at this level for the next ten years, even
as housing prices rose.

SOURCES: Author’s calculations based on data from National Association of Realtors;
U.S. Department of Commerce, Bureau of Economic Analysis; and Federal Home
Loan Mortgage Corporation.

Housing prices, income, and interest

Recent years have seen long-term interest
rates, including mortgage rates, decline
significantly.6 If potential homeowners
determine the price they are willing to
pay by the size of the mortgage payment
it generates, then lower interest rates
can lead to higher house prices. I create
a mortgage-servicing index by assuming
that a home buyer uses a down payment
equal to 20% of the purchase price and
finances the rest with a 30-year fixedrate mortgage. Then, the mortgageservicing index is simply the ratio of
mortgage payment on the median sale
price of an existing single-family home
to the median household income. Viewed
through this lens, figure 2 shows that
housing is more affordable now (that is,
the index is lower) than it was ten years
or 20 years ago. It takes less than 16%
of the median household’s income to

We can use the mortgage-servicing index
to test the effects of increasing interest
rates on housing prices. Figure 3 shows
that for modest increases in interest rates,
the decline in housing prices will also be
modest. The simulation in the table looks
one year ahead, assuming that nominal
income rises by 5% (approximately the
rate of change in recent years). In 2004, the

average mortgage rate was 5.8% and
the mortgage-servicing index was
15.8%. If mortgage rates and the
mortgage-servicing index continue at
the same levels for 2005, house prices
will increase by 1.0%, reflecting the
impact of the assumed increase in income. However, most analysts believe
that mortgage rates in 2005 will be
higher than they were in 2004. As of
February 2005, the Blue Chip forecast
of mortgage rates for the fourth quarter of 2005 ranged from 5.9% to 7.6%
with a mean of 6.5%. If mortgage
rates rise from 5.8% to 6.5% and the
mortgage-servicing index remains at
its year-end 2004 value of 15.8%, then
housing prices will fall by 6.5%. The
1994 experience indicates that, in
the short run at least, the mortgageservicing index is likely to stay steady
or rise somewhat following a mortgage
rate increase. This suggests that any
decline in housing prices will be modest if mortgage rates rise to 6.5%. Of
course, larger increases in rates translate to larger simulated price decreases.
For example, if mortgage rates were
to rise to 7.5% in the fourth quarter
of 2005 while the mortgage-servicing
index remained constant, housing
prices could fall by 15.5%. In this case,
homeowners would lose roughly three
years’ worth of price increases.
Seventh District housing market

Because housing markets are by their
nature local, and examining national
trends can miss important differences
across markets, I review changes in
prices and affordability for selected
markets in the Seventh District, comparing them to other major markets.
Home prices in the Seventh District
are generally below national averages,
except in the Chicago metropolitan
area. While housing prices have increased over the past 20 years, the rate
of increase has varied significantly
across the Seventh District—it was largest in the Chicago metropolitan area
and smallest in the Indianapolis metropolitan area. Prices in the Detroit
and Milwaukee metropolitan areas have
shown significant strength throughout
this period, while in Chicago and, to an
extent, Milwaukee, prices have increased
more rapidly in the past few years.
Although prices have increased,
housing affordability in the Seventh
District has generally stayed the same

4. Mortgage-servicing index, 7th District metro areas

















S OURCES: Author’s calculations based on data from National Association of Realtors;
U.S. Department of Commerce, Bureau of Economic Analysis; and Federal Home
Loan Mortgage Corporation.

is no evidence of the
rapid growth seen in
other areas such as
Prices in the Detroit
metropolitan area
jumped in the late
1990s, but have increased at a much
slower rate since then.
The evidence suggests
that Detroit is less affordable than other
local markets, but the
affordability gap has
closed significantly in
the past three years.
This is driven at least
in part by the weak
economic conditions
in the area rather than
by the bursting of a
housing price bubble.

For reference, figure
5 shows the mortgageservicing index for
the Boston, New York,
and San Francisco
metropolitan areas.
Not surprisingly, housing is less affordable,
and the mortgage40
servicing index is
much more variable,
in these areas than in
the Seventh District.
The mortgage-servic20
ing index in San
Francisco fell from
52.5% in 1989 to
1985 ’87
’99 2001 ’03
31.8% in 1998, before
New York
rising to 45.0% in
San Francisco
2004. Boston had a
SOURCES: Author’s calculations based on data from National Association of Realtors;
similar swing in afU.S. Department of Commerce, Bureau of Economic Analysis; and Federal Home
Loan Mortgage Corporation.
fordability, with the
index falling from
29.7% in 1987 to
or declined somewhat. Figure 4 shows
18.6% in 1993, before rising to 27.7%
the mortgage-servicing index for the
in 2002. Since then, housing prices
Chicago, Indianapolis, Detroit, and
have declined in the Boston metropolMilwaukee metropolitan areas. Notaitan area, and the mortgage-servicing
bly, homes remain more affordable in
index was down to 22.8% at the end of
Indianapolis than elsewhere in the
2004. These factors alone do not indiDistrict. Both Chicago and Milwaukee
cate bubble-like conditions in any of
track the overall U.S. mortgage-servicing these markets. However, the recent inindex quite closely. While prices in both crease in prices in New York and San
areas have risen in recent years, the inFrancisco leave those markets with
creases are only slightly more than in the housing that is much less affordable
country as a whole and affordability
than their 20-year averages.
has not decreased significantly. There
5. Mortgage-servicing index, selected metro areas


The rapid rise in housing prices has led
some observers to fear that we are in the
midst of a housing bubble. Housing
prices have indeed risen in recent years.
However, the increase in housing prices
has come at the same time as mortgage
rates have declined and incomes have
increased. I present a simple mortgageservicing index that indicates that these
two factors have kept housing affordability for the United States as a whole
roughly constant as housing prices
have increased.
Further, housing price increases in the
Seventh District have been moderate
compared with increases in some other
parts of the country, such as some
markets on the East and West Coasts.
Housing affordability has generally been
stable and near the national average in
the District. The analysis here suggests
that if mortgage rates rise, housing
prices in the country as a whole, as well
as in the Seventh District, may stabilize
or fall slightly. If housing affordability
remains roughly constant, any decline in
prices is likely to be moderate. Even if
mortgage rates rise to 7.5%, well above
their 5.8% average for 2004, housing
prices in most markets are likely to remain at or above their 2000 levels.
One limitation of this exercise is that I
use the median sale price of an existing

Michael H. Moskow, President; Charles L. Evans,
Senior Vice President and Director of Research; Douglas
Evanoff, Vice President, financial studies; David
Marshall, Vice President, macroeconomic policy research;
Richard Porter, Senior Policy Advisor, payment
studies; Daniel Sullivan, Vice President, microeconomic
policy research; William Testa, Vice President, regional
programs and Economics Editor; Helen O’D. Koshy,
Editor; Kathryn Moran, Associate Editor.
Chicago Fed Letter is published monthly by the
Research Department of the Federal Reserve
Bank of Chicago. The views expressed are the
authors’ and are not necessarily those of the
Federal Reserve Bank of Chicago or the Federal
Reserve System.
© 2005 Federal Reserve Bank of Chicago
Chicago Fed Letter articles may be reproduced in
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Prior written permission must be obtained for
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single-family home.7 Thus, there may be
trends in housing prices for particular
segments of the market that are missed
by this analysis. For example, the most
expensive homes in a market may be
more vulnerable than the median home
to changes in mortgage rates. If so, then
prices for these homes might moderate
more when rates rise.

Another limitation is that the mortgageservicing index assumes borrowers use
a traditional fixed-rate mortgage. As
mortgage rates increase, some purchasers may use more aggressive financing
options, such as adjustable-rate mortgages or interest-only mortgages.8 If
rates continue to rise, these borrowers
may feel the pressure to sell more than






Often the claim that there is a bubble is
based on an increase in prices. However,
even if prices are too high, there may not
be a bubble. According to Edward Leamer
of UCLA, the term “bubble” might be a
misnomer since housing price declines
are “very slow, painful processes” (San
Francisco Chronicle, February 10, 2005).
The Seventh Federal Reserve District
comprises all of Iowa and most of Illinois,
Indiana, Michigan, and Wisconsin.
Other rent indexes give similar results.
See Edward Leamer, 2002, “Bubble trouble? Your house has a P/E ratio too,”
UCLA, Anderson forecast, June.
See, for example, Wall Street Journal,
2005, “In the hottest markets, renting is
the real bargain,” March 22.



After declining through 2002, mortgage
rates have moved in a narrow range in
the last few years. They have not risen
significantly since the Federal Reserve
began raising interest rates in June 2004.
The Census Bureau puts out an index
constructed to hold housing quality constant at 1996 levels (called the price index of new one-family homes sold including the value of the lot). An analysis using this index gives qualitatively similar
results to the data used here.
According to the Mortgage Bankers Association, the percentage of mortgages that
are adjustable rate averaged 18% from

those with more traditional mortgages.
In addition, as Federal Reserve Chairman
Alan Greenspan noted in a recent
speech, there has been an increase in
the share of homes purchased for investment.9 Again, speculators may be quicker
to sell if house prices start to weaken.
This could put additional downward
pressure on prices in some markets.


1998 to 2003 but rose to 46% in the second half of 2004. In addition, the rate of
interest-only mortgages has gone up in
recent years. According to a study conducted for the Wall Street Journal, 61% of mortgages in California during the first two
months of 2005 were interest-only compared
with less that 2% in 2002 (Wall Street Journal, May 17, 2005). Nationwide, the proportion of interest-only loans was 17%.
Speech by Federal Reserve Board Chairman Alan Greenspan on globalization to
the Council on Foreign Relations, New
York, March 10, 2005.

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