Housing price conundrum (part 2) | Current Economics | Finance & Capital Markets | Khan Academy

Before I go a into an
explanation of why housing prices skyrocketed from 2000 to
2006, I think it's a good idea to give a little history of
what the housing market and the mortgage market used
to be like before things got out of control. So let's go back to,
say, I don't know. Let's go back to
the late '70s– maybe mid-'70s, actually. I remember my parents,
they bought a house. We lived in New Orleans. And the house, if I remember
correctly, it cost roughly $60,000. And back then, to buy a house —
and actually, for a while, until more recently — in order
to buy a house you had to put 25% down. So 25% of $60,000
is 1/4 of it. So you have to put
$15,000 down. So you have to save
up $15,000. And then you're going to get a
mortgage on $45,000, right? $45,000, you're going
to borrow.

And I forgot the exact interest
rates then, but I'm just going to throw
out a number. This is really just for
instructive purposes. Let's say interest rates back
then, they were higher. They were like 9%, I think. So 9% on $45,000. How much interest am
I going to pay? 45,000 times 0.09. So I'm going to pay a little
over $4,000 a year in interest. Or if I divide by
12, about $340 a month in interest. And I remember at the time, we
actually moved out of our house and we rented it out,
because we needed cash. And we rented out that exact
same house — and I this is in the late '70s or early '80s– we
rented out that exact same house for $900. The rent was $900. So this raises, I guess,
a couple of questions. First of all, the big question
is, why did those people who rented our house — I mean,
they paid $900 a month.

They must have had a good
income, for that time. Why were they willing to pay
rent, when they could have bought a house, where the
mortgage would have been — interest plus a little principal
— it would have been no more than
$400 a month? So why would you just throw away
— this is the classic rent-versus-buy argument — why
would you throw away $900, where you could actually build
equity paying $400 a month for the exact same place? And you can think about
that a little bit. But there's a bunch
of reasons. What was necessary to
buy a house then? Well, one, you needed a
$15,000 down payment. Maybe these people had really
good cash flow every month, but they just never had the
circumstances, or maybe even the discipline, to
save up $15,000. You also needed a really
steady job. So you needed — this
is the down payment, this is one thing.

You also needed a steady job. Maybe the people who were
renting, they were working odd jobs, or they didn't have
a steady income. Although I doubt it. I don't think we would have
actually leased the house to them, had that been the case. They probably had that. And then the last thing you
needed to get a mortgage, you needed good credit. And maybe these people
didn't have that. Maybe they didn't pay some bills
in the past. And they just couldn't find a bank that
was willing to give them a loan, despite having a steady
job and the $15,000 down. If you have to ask me, I think
the biggest barrier for this family at that time
was probably the $15,000 down payment.

And frankly, they probably had
trouble saving $15,000 because they were busy paying
$900 in rent. So that was the circumstance
throughout, actually, most of modern history. That you had this barrier
towards buying a house. That it did make sense, that the
conventional wisdom that it is better to buy
than rent held. It's just, everyone knew that,
but a lot of people just couldn't buy, even though they
wanted to, because they didn't have the down payment. They didn't have
the steady job. Or they didn't have
the good credit. That was a circumstance then,
and that lasted for some time. What happened in the
early 2000s? And it actually happened in
California in the mid-'90s. But it got more and more, I
guess we could say, flagrant, as we went through the decade–
is that people started lowering these
standards. And I'll do a whole other video
on possibly why those standards were lowered.

But let's say that in 1980
you needed 25% down. Let me just switch colors. That color is kind of ugly. You needed a steady job. And you needed a,
I don't know. Let's say you needed
a 700 credit score. And that was true from 1980
to, let's say, 2000. I'm exaggerating a bit. But this is just to give you
the broad sense of what actually happened. But let's say then, in 2001 —
and I'll explain later why this might have happened — the
standards were lowered. That if you wanted to buy a
house, all of a sudden you could actually find someone who
was willing to give you a house for 10% down, maybe kind
of a steady job, maybe just need a job.

And maybe you had a
600 credit rating. So what happens when the
standards on the mortgage go from this to this? Let's go back to these people
who used to rent that house from us for $900. Maybe they didn't have
$15,000, right? That would have been
a 25% down payment. But maybe back then,
they had 10%. Maybe they had $6,000. They just couldn't get up
to $15,000 in savings. Back when they were doing this,
back in the '80s, if the standards got a little bit
freer, like they did in the early 2000s, those people could
have bought a house. They would have said, man, we
don't have to rent anymore. We saved up the 10%
down payment. It's gotten a little easier. Our job now meets the
requirements. Our credit now meets
the requirements. We can go buy that house.

So that would have
increased the aggregate demand for housing. Even though, even if no one's
incomes increased, even if the population didn't increase. All of a sudden, there's a new
person who could get financing to buy a house. And then if we go to,
let's say, 2003. They say, you know what,
you don't even need any down payment. No down. No money down. So you can imagine, there's a
whole set of people who maybe had a decent income, but they
couldn't save any money. Now all of a sudden there was
no down payment barrier to buying a house. Maybe you still needed a job. And maybe you just needed
a 500 credit. Right? So all of a sudden, without
people's incomes going up, without more jobs being
available, without the population increase, there
were more people who could get financing. Or more people who could
bid up homes. And the situation actually
got pretty bad. By 2004, 2005 — and this isn't
exact, but it gives you a sense of what happened.

By 2004, 2005, you had a
situation where they had these stated income — they had these things called liar loans. Maybe I'll do videos
on each of these. But these were essentially
no down payment. If you had a job, you could
kind of make it up. You just said, I have a job. They wouldn't validate it. These were stated income. You could just say
what you made.

So even though the mortgage
might require an income of $10,000 a month, and your income
is only $2,000 a month, you could say your income
is $10,000 a month. So stated income, no
down, maybe a job. And they didn't even
do a credit check. So what happened from 2000 to
2004 is that credit just got easier and easier and easier. And every time credit got
easier, there were more people who, despite the fact that they
weren't making any more money, they were able
to get financing. And so the pool of people who
were able to bid on homes, or the demand for homes because now
there was this financing, became larger and larger. And that's what increased
the prices of homes. And now you know, the obvious
question is, well, why did this happen? First of all, why did they get
easier in 2001, get easier and easier as we went to 2004? And why did they get to this
unbelievably absurd level, where by 2004 and 2005 — you
hear stories, especially in California and Florida, of
people who were making maybe $40,000 a year.

And they were able to buy houses
with no money down. Some of these people were
migrant laborers. And they were able to buy
houses for $1 million. So in the next video, I will
tell you why that happened. Why were people willing to give
their cash to people to buy a house that had a very low
likelihood of getting paid back, and for a house that had a
very low likelihood of being able to retain its value. I'll see you in the
next video..

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