The California Association of Realtors, recently released a survey indicating that Californian’s where $70,480 short of income to afford a median home priced at $530,430, even worse for San Francisco Bay Area where the shortage in income is $102,230. These numbers assume a 20% down payment, with monthly payments for principal, interest, taxes, and insurances that are no more than 30% of the household’s total income. Based on the Fed’s interest rate hike this week, how much can this hike increase the income necessary to afford a home?

This week the Federal Reserve raised the interest rates by another 1/4 percent, with another raise expected on September 20 of this year. Assuming housing prices don’t change and an initial interest rate of 5%, that means that on September 20 (assuming another expected 1/4 percent interest rate hike), Californians will have to come up with an additional $133.29 a month, or gross income before taxes of another $205.27/mth. That’s $2,463.20 a year. In other words, the median affordable income will then be raised to $72,943.20 a year, an increase of salary of at least 3.4%.

If interest rates keep climbing, the real estate market is in for a lot of problems. Although $2,463.20 in additional income a year might not seem like that great an increase considering the scale of things, note that that’s just two minor rate hikes with more expected in the near future! And not only that, but according to BusinessWeek.com, 31% of all new single-family mortgages in 2004 were interest only! This means that many people are already financially stretched to their very maximum. And do remember, the numbers above are with a 20% down payment which is not nearly as common with interest only mortgages. Assuming the worse case, a 0% down payment and an interest only loan with the same 5% rate, the monthly amount is $2,210.12. Now add the two rate hikes to that rate and you get a monthly payment of $2,431.13, an increase of $221.01/mth, or $4,048.26 a year, almost double! And don’t forget that interest only loans generally have higher interest rates.

As you can see from these numbers, if interest rates continue to climb, we’re definitely going to see real estate housing prices drop. The good news is that you can plan ahead and protect yourself today. You can, for example, refinance your property and lock in today’s low interest rates for longer terms, the longer the better. And if you do purchase a new property, you should avoid purchasing at the upper limits or your budget and especially avoid interest only mortgages.

Now that we know the income required to own a home in California, let’s look at the numbers from another perspective. How far do real estate prices need to decrease to make housing affordable to Californians today?

Given the same 20% down payment, the mortgage amount comes to about $430,430 (20% is actually $424,344, but we’ve rounded it up a little to add some acquisition costs). Assuming the same 5.5% interest rate, we have a monthly mortgage payment of $2,443.93, making our yearly payment $29,327.16. At this point we have two options, we can determine how the survey calculated their numbers or we can make a rough approximation. For the scope of this article, we’ll use the rough approximation approach. Since we know that as we lower the housing prices some of our other numbers will also be relatively affected we can safely assume that the decrease will likely be less. As an example of such an affect, lowering the price of a property should also lower the insurance costs as it requires less coverage. Using our rough approximation, we can take the percentage difference of the required income of $124,320 and the shortage of $70,480 to give us an income shortage percentage of 56.7%.

What this means is that we need to drop the price of our mortgage by as much as 56.7% to make housing affordable today for Californians. Or in other words, the real estate housing price needs to drop from $$530,430 by approximately 56.7% to $300,753.81! That’s a large difference.

Odds are that real estate prices won’t decline this drastically because, as mentioned just above, if you add other factors such as inflation, insurance, taxes, etc., the drop will be a slightly less. How much less exactly, I’m not sure. But if you assume a drop 56.7% then you should be safe. And based on the past history of the real estate market, such drops have existed before. The good news is that no bust has yet lasted for more than 10 years. So again, if you’re going to buy in today’s market, buy with a long term fixed interest rate with the expectations that there will likely be a significant price drop before for some time.

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