FinLit Newsletter 10-18-2023

Mortgage rates are at the highest levels since 2000, with the Mortgage News Daily Rate Index showing the average 30-year fixed mortgage at almost 8%.

The mortgage market is a critical piece of the economy, and normally gets special attention because middle class consumers usually have an outsized proportion of their net worth allocated toward homeownership. This is in contrast to high net worth consumers, where real estate may be just one piece of a large portfolio of assets, and low income households, where the household may renters and not own any assets at all. Note that, real estate prices also influence rent prices, so lower income households are also impacted indirectly, while middle class households are impacted more directly.

How housing prices help or hurt the middle class

Generally speaking, rising housing prices are regarded as desirable for the middle class for a few reasons:

·         Since it is a significant portion of middle class household wealth, overall household net worth increases when your home value increases

o   And for those that are prospective home buyers, if you believe housing prices are going to continue to go up tomorrow, it’s ok to “overpay” today (the issue is if you overpay and prices come down, which we’ll get into).

·         It allows the middle class access to leverage: buying a house with a mortgage gives you access to a significant asset while only having a fraction of the cash on hand to purchase the asset. Institutions and high net worth households constantly utilize leverage for a variety of investments; for the middle class, this is one of the few asset classes where they can take advantage of a leveraged investment. If the price of the house goes up, your investment returns will be higher than if you purchased the asset with all cash.

·         It can be used as liquidity: similar to leverage, liquidity management is something that is normally something that institutions and high net worth households deal with – the process of getting cash out of assets, which you can then turn around and use elsewhere, perhaps for further investment opportunities. If a middle class homeowner has a $500k house with a $100k mortgage, they might be able to refinance their home, and take out an additional $100k mortgage using the existing equity in the home. That $100k can be invested elsewhere, while they still own the house as well. Institutional investors do things like this constantly – leverage existing assets against new investments and assets.


This is why the middle class generally likes increasing housing prices. For lower income or lower middle class households, they can have trouble even coming up with a down payment to access homeownership, if housing prices rise too dramatically. Also, for non-homeowners, as we mentioned, rent burdens would likely increase as well, since they are strongly tied to real estate prices.

Now let’s look at what happens to homeowners during a housing crash / housing bubble.

What happened to many homeowners during the housing bubble and crash of 2008

As we mentioned, the purchase of a house is a process that usually involves leverage in the form of a mortgage. Like any tool, debt / leverage is something that can provide enormous power, both positive and negative. It must be understood and respected before you use it, otherwise, it can burn you significantly.

Here’s an illustrative example of how homeowners got burned during the last housing crash in 2008.

Let’s say you bought a house for $300k, with $50k down payment and a $250k mortgage. Your equity is the value of the asset minus debt, so $50k. This is your “net worth”.

Let’s say your house appreciates in value to $375k because your market is red hot. Holding all else equal, this increases your equity, your net worth, to $125k (exclude for now the fact that you’re paying mortgage payments, keep this example simple).

Here’s a simplified look at the home value increasing and how your personal net worth increases relative to the mortgage.

Now let’s say you want to take advantage of this increased home price, which many, many people did in the years leading up to 2007/2008. What you might do is take out debt against the value of your home. You could do this via refinancing, a home equity line of credit, etc.

In this example, our homeowner will take out a new mortgage, increasing the mortgage size to $345k. This gives net new cash of $95k at the trade-off of lowering home equity by the same amount.

Maybe the homeowner had a brilliant investment idea, wanted to start a new business, or simply wanted to renovate the home with the cash. The homeowner’s total net worth doesn’t change, but the equity in the house decreases because it has been taken out and converted to cash – a liquidity event.

Now let’s say that, unfortunately, a crash happens followed by an economic downturn. Perhaps the homeowner’s investment idea didn’t pan out, or the cash was spent on the house, which crashed in value anyway. Let’s say the home value crashed back down to the original $300k purchase price.

Now, your asset is $300k but you have $345k of debt on it. This asset is underwater. The homeowner will have trouble selling the house for anywhere near what they expected it to be worth when the refinanced, and they’ll also be prevented from doing other things involving credit like buying a car or financing anything, until this is resolved. It would be difficult to buy a new house because a down payment will be even more difficult to procure, given that they’ll have to use $45k extra to pay down the extra mortgage balance if they ever want to sell their house at current market prices.

Here’s what our homeowner’s financial situation looks like over time now, with the Home Equity portion now negative.

Leverage can be a powerful tool to create immense wealth and returns when used correctly, but it can also burn people that either don’t have a financial cushion or that utilize it without fully understanding how it works. 

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