Why Home Prices Skyrocketed

The easiest way to explain why home prices skyrocketed so quickly is with a graph…

Demand GraphI made it myself.  I kinda like it.  The 1 million figure is an arbitrary number I chose for this example, the actual number is probably different but the concept is the same.

Banks love to make home loans to Category 1, the prime borrower.  They have 20% or better for a down payment, excellent credit, solid incomes, etc…  Banks will also make most loans to Category 2.  This is someone who has most of what a prime borrower has, but is marginally lacking in some area.  Once you get to Category 3 however, different banks handle it different ways.  Some banks will simply refuse to make the loan, others might with a higher interest rate.  Then there is Category 4, the worst borrower.  This is someone with really bad credit or nothing for a down payment.  They might have a low paying job or have spotty employment history.  This person will default on the loan.

For generations, banks have made loans mostly to the first and second categories, only.  This represents the demand, or the number of buyers, looking for homes for sale.

So let’s assume each couple icon in my pyramid represents demand for 1 million houses in a given year.  That means that each year, banks provide loans that fuel demand for roughly 3 million homes.  One million from the “prime” category and two million more from the “slight risk” category.


This translates to the selling or construction of 3 million homes annually.  Based on that demand, individuals decide to sell or not to sell and builders decide to build or not to build.  This demand was consistent year after year and decade after decade, which allowed builders to determine how many homes to build and set the price that sellers could sell for.  It was consistent, simple and predictable.


But when the government forced banks to begin lending to low-income individuals and families, it threw the demand out of whack.  Suddenly, people from the “some risk” category became “qualified buyers” even though they would never have qualified normally.  In an instant, demand went from 3 million homes per year to 7 million homes per year.

7 MILLIONSince building a home takes longer than baking a pie, there simply was not enough supply and prices began to rise.

As well when the government lowered interest rates, some of the “unqualified high risk” people entered the market.  Lowering interest rates effectively lowers the total cost of ownership…so people who simply could not buy homes at 8% interest suddenly could at 6%, with even more people qualifying at 5% and so on.

Then by tossing common sense lending standards that had been in place for generations out the window by not requiring anyone to prove an income, have a job, pay any interest at all with teaser rates and negative amortization loans, the entire bottom of the pyramid, Category 4, suddenly, overnight, become “qualified” home buyers.


It only took the government a few years to move tens of millions of “unqualified” home buyers to “qualified” status which put a strain on demand for housing unlike any in history.  When the demand curve goes straight up, and supply can not keep up, the pressure is released through prices.  Pricing is the free markets natural response to balance supply with demand.

As home prices rise, technically, fewer and fewer people should be able to afford them which slows demand until a price equilibrium is met where the demand at a particular price meets the supply available at that price.  The government, through their unnatural intervention in the free market place would not permit price equilibrium to occur by simply removing the rules that would have made many people ineligible for loans.

This is what caused the price of homes to reach unfathomable levels.  They were never worth those prices.  When 39 million people are suddenly fighting for 3 million homes, prices skyrocketing into the stratosphere is what you get.


Builders incorrectly assumed this demand would continue and rapidly expanded to meet a world that now, suddenly,  demanded 39 million new homes a year.  When the bubble imploded, not only did all those Category 4 and Category 3 borrowers go into foreclosure and release a glut of properties onto the market, builders were left with millions of partially completed houses that they had no choice but to abandon, or complete and sell at greatly reduced prices.

Supply and demand, it’s a beautiful thing.

Categories: Housing Market

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