Soaring mortgage rates have led to the worst affordability in almost four decades, while sellers are also losing their ability to move up to more desirable homes. On Friday, October 14, 2022, the current average 30-year fixed-mortgage rate was 7.04%. Not only are mortgage rates at a 20-year high, but inflation is raging, and the stock markets are tanking. People are spending more on day-to-day living while their investments are shrinking. No way does this bode well for the housing market. The next several months will be a critical test for the economy, experts say.

Homeowners are Losing Wealth

This may surprise you, but home prices dropped 0.77% from June to July, according to a recent report from Black Knight, a software, data, and analytics company. That’s a very small decline and isn’t immediately raising red flags but it was the first monthly drop of any size in 32 months. That minor drop in sales prices is not an immediate cause for concern because annual home price appreciation is still expected to come in at over 14%. But that is not the whole story…

Other factors are weighing down homeowner wealth. Homeowners looking to tap into their equity by refinancing are seeing a national average 30-year refinance rate of 7.07% in mid-October. Of course, more than doubling the refinance rate makes it much more expensive for homeowners to access the steep appreciation homeowners have come to expect over these past several years. The data suggests refinancable home equity probably peaked in May.

Accumulatively, there is a sea-change happening that makes backward-looking metrics much less reliable today. What is more important today is watching trend lines. It’s too early yet to say that home prices are on a downward trend. While home prices tend to have a seasonal downward shift as summer ends, this year the numbers were larger than the average. Usually, we see a decrease of 2% from June through August, but this year that decrease was 6%. That trend line is developing into a cause for concern that the housing market is headed for a correction.

A Correction Does Not Mean a Housing Crash

We’ve been able to see this correction coming for many months if not a year or more. Warnings that home prices had become unaffordable have been evident since well before hyperinflation hit. And before interest rates took off. Summer sales were somewhat kept afloat after mortgage rates went up rapidly in the early months of 2022, but dipped in June at just below 6%, before settling into the mid-5% range for most of the summer. Today, we are above 7% with expectations that the Federal Reserve will continue to steadily increase interest rates each month through February. Mortgage rates can easily be expected to reach 8% in the months ahead — just before a recession is strongly expected to occur. With a recession, already slowing home sales will come to a grinding halt with sellers forced to lower prices to attract any offers at all.

Fortunately, homeowner economics are vastly different today than the last time the housing market saw a significant correction. The Great Recession of 2007-2008 was primarily caused by the ‘subprime mortgage crash.’ Immediately before the crash, lenders were approving mortgages that had almost no chance of being repaid. The housing market was so hot that lenders assumed appreciating values were the underlying security for the loans. One of the worst types of loans made back then are known as ‘negative amortization loans.’ These had a payment structure with scheduled payments at less than the interest charged on the loan. The deferred interest was tacked on to the principal at the end of the loan. In a few short months, the homeowner had a mortgage balance that was more than the value of the loan. These (and similar loans) soon became ‘underwater mortgages.’ As buyers realized how much trouble they were in, many tried to sell their houses but could not sell for enough to pay off the underwater mortgage. The housing market spiraled downward into massive foreclosures that ended up costing lenders billions in losses.

Fortunately, that is not the situation with the housing market today because strict lending standards have been in place as a result of the subprime mortgage crash. Today’s slowing house market is because buyers cannot qualify for high-interest loans. On the positive side, people that already own their homes have outstanding mortgage balances that average only 42% of the actual home value. Homeowners have equity which averages 58% of homes valued at over $400,000. That is a lot of skin in the game. It is the lowest percentage of outstanding balances on record. Losing some value on paper shouldn’t affect those owners at all.

Still, that is an average and doesn’t mean every homeowner is safe as we see a correction trend developing in home values. The most recent homeowners that bought for top dollar and with a 6% mortgage are likely to soon be faced with high mortgage payments for a house that is worth less than the mortgage balance. It’s estimated there are about 275,000 borrowers who would fall underwater if their homes were to lose 5% of their current value. Almost all