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Home Sale Prices - How Can They Be so High?

By - 2008

We can see that the real estate bubble has burst, but how did home sale prices get so high in the first place? My wife and I were in San Francisco and the surrounding areas recently (2008), and were amazed at the prices there. A home that sells for $100,000 where we come from in Colorado can be as high as $600,000 in San Francisco, Monterey, Santa Cruz or San Jose - and I don't mean ocean-front homes.

Furthermore, this is after the real estate bubble burst - or so we thought. According to a report we saw on the news one evening, parts of the San Francisco Bay area have still seen double digit increases in home prices over the last year.

Of course, other areas have been hard hit. In fact, some towns in California have seen prices drop in half in a matter of two years. But how did they get so high to begin with? How do whole populations of people buy homes that average a half million dollars or more? After all, some of those buyers must work at regular jobs, making only $30,000 to $40,000 per year.

There are several factors that lead to the high prices, and some of them are still in place. That could mean that prices might not fall much further. Then again, it could mean that if and when we see those factors change, further big declines will happen. Let's take a look at this.

Low Interest Rates Equal High Home Sale Prices

Here is an interesting little experiment you can try for yourself. Get out an amortization book or find one of those payment calculators online. See what the payment would be for your home at 13.5% interest. That is what people were paying in the early 80s, by the way. A 30-year loan of $100,000 would cost you $1,146 per month for principle and interest.

Now look at how much you can borrow at 5.5% interest. That's as low as my old amortization book goes, and lower rates were certainly possible a couple years ago (although they were often teaser rates on adjustable rate mortgage loans). For the same monthly payment, you could borrow $202,000. In other words, the sales price could be twice as high, and yet you could pay less each month, and for the same number of years. You can see why low interest rates allow prices to rise.

Of course, there is more to it than that, since prices certainly more than doubled in most areas over the last twenty years (some doubled in two or three years a short while ago). So what else lets them go higher?

Higher Incomes

As incomes rise, people are able to pay more for housing. More people who rent might be interested in owning a house as well, and so the demand goes up, driving prices higher. Of course that doesn't quite explain the extremes. After all, even with a decent income of $60,000 per year, how does one afford a $500,000 home?

Changing Expectations

During the real estate bubble, people came to expect home prices to rise faster than inflation. Because of this, they were convinced that a home is a great investment, and were willing to stretch their budget to buy one. Where devoting no more than 30% of your income to a house made sense before, now buyers were willing to spend up to half of their paycheck on their home.

More than that, though, there was a frenzy to get in on the home price appreciation we all saw. So although a couple might not actually be able to afford a home, they could buy it with easy credit terms, drain their savings to make the payments for a couple years, and then before they ran out of money, they could sell for a profit. This kind of speculation became especially common in California. Of course, now that prices are falling, there are record rates of foreclosure. The game is over.

Other Factors That Help Explain Home Sales Prices

Easier loans allow more people to buy, which certainly helped increase demand, and therefore prices. After all, even those with decent income used to have to save for a down payment. No-money-down mortgage loans changed that. Also, interest only loans, which included half the loans made in California at the height of the bubble, kept monthly costs lower. That $1,146 mentioned earlier pays for a $250,000 loan with interest only.

Now add the fact that both husband and wife work more often than not now, and you can see that they can pay a lot for a house.

Finally, there is one more factor that we discovered while in San Francisco. More than one person told us that people are sharing houses more than ever. One man told us that when he lived in San Jose, most of the homes in his suburban neighborhood had four families living in them, with perhaps six or more incomes helping to make the payments. This is a cultural thing (most were Asian or Hispanic), since many people born here don't like the idea of living with other families. But nonetheless, the fact is, those who are willing to do so have found a way to afford a $600,000 home, and this supports the high home prices in the area.

Of course, in the end a big part of the answer to how people can afford high home sale prices is that they can't. That's why we are currently seeing record after record being set for foreclosures. If we see interest rates rise in addition, we will see further declines in those prices.

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