According to The Economist, a well-regarded British journal of opinion and analysis, "house prices are at record levels in relation to average income in America, Australia, Britain, Ireland, the Netherlands and Spain. The prices of British, Irish and Dutch homes are now 50 percent above their 30-year average relative to incomes. By the same gauge, property is 'overvalued' by 23 percent in America, by 33 percent in Australia and 68 percent in Spain." (See: "Homing in on trouble," March 13th-19th, 2004)

Looking at research from the Bank for International Settlements, the magazine says home prices typically peak two years after stock markets. For us, it's now year four since the last Wall Street crash, the one that saw investors lose equity worth some $5 trillion.

What's happened is that as interest rates have fallen people have taken on more debt. People have also been able to buy larger and more expensive homes with a given amount of income. The question is whether people have taken on more debt than they should by bidding up home prices unrealistically. If the answer is "yes" then forecasters argue that prices should fall.

For instance, if you borrow $250,000 at 7 percent interest over 30 years the monthly cost for principal and interest is $1,663. If interest levels fall to 5.5 percent -- about where they are now -- that same monthly payment could finance $292,936.

The fear is that if interest rates rise home prices will decline while home sales tumble.

How realistic are such predictions? What would be their impact?

One historic fact is this: According to the National Association of Realtors, home prices nationwide have risen on a cash basis every year since 1968. A second historic fact is this: That home prices have increased each year on a cash basis does not mean they have increased in value after inflation. In other words, if dollars buy less it takes more dollars to buy a given item. Also, that prices have risen nationwide does not mean they have risen in all locations. Some local communities have seen price declines that have lasted for years.

There has never been a shortage of forecasters who believe that real estate is overpriced. While such prophecies have typically been wrong, real estate is a commodity, commodity values can rise and fall, there is always risk in the marketplace and there are no guarantees that real estate values will always rise, everywhere and forever.

No less important, it's difficult to figure local home prices. For instance, if home sales this year include a larger percentage of small homes or condos than last year, it's likely that average home prices will appear to fall even though actual values have remained stable or perhaps risen.

So what are we to make of the latest predictions?

Imagine what would happen if home prices fell 20 percent nationwide over a year or two.

• If you have an adjustable-rate mortgage (ARM), then higher indexes will lead to steeper rates and larger monthly payments. For those on the cusp of affordability, such increases can lead to foreclosure and bankruptcy. The $250,000 loan at 5.5 percent interest today may cost $1,420 a month for principal and interest, but at 7.5 percent the cost rises to $1,748 -- and most ARMs allow interest increases of up to 2 percent annually.

• If you have a job and monthly mortgage costs rise, then it's likely that new and higher payments can be met. That said, you will have fewer dollars for other purchases or savings.

• If you bought a home 10 years ago at $150,000 that is today worth $250,000, you're ahead. If you have to sell at $200,000 you're still ahead. If you bought with 5 or 10 percent down you have done astonishingly well on your cash investment.

• If home prices fall owners will have less equity -- that means less ability to use financing secured by real estate to pay off consumer debt, expand a small business or pay off car loans.

• Higher interest rates and less equity would reduce mortgage origination activity, meaning we would have fewer loan officers and lenders.

• Higher interest rates would reduce home sale activity, meaning fewer brokers and smaller national association memberships.

• Leverage works both ways. Owners who have bought with little or no cash may be "upside down" if they are forced to move; that is, they may owe more than the property is worth. In such cases, selling and moving may be impossible.

• Bankruptcy rates -- now at record levels according to the American Bankruptcy Institute -- will grow larger, not good news for anyone.

• If you have a comfy fixed-rate loan then rising rates will not be a mortgage issue for you.

• If you're not selling, then home prices changes are not an immediate concern.

• If you're not refinancing, then new rates and falling equity are distant issues.

No one knows what will happen in the future, but is it unreasonable to believe that interest rates will rise? Given higher rates, would anyone be surprised if home sales slowed and values in some communities, at least, declined?

As to a reduction of 20 percent or so, that seems unlikely. Why? Because most of the housing stock is not for sale; much of the housing stock has been and is being refinanced at low rates; and an overwhelming proportion of the population is employed.

Still, are there steps you can take to protect your interests just in case rates rise or home values slacken?

Sure. Get a fixed-rate mortgage at the lowest possible rate. Reduce consumer debt -- that can't hurt whether interest rates rise or fall.

For more articles by Peter G. Miller, please press here.

Published: March 23, 2004

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