Special report: Why common housing affordability measures are wrong

By Leith van Onselen

In recent times I have witnessed excuses about today’s record high house prices (and record low affordability) that do not pass the laugh test and warrant thorough debunking.

The first is the claim that when mortgage rates halve, this means that a buyer can afford to purchase and pay-off a home twice the price.

This claim is easily debunked by the below stylised example.

Scenario A (high price, low inflation):

  • Buyer has an annual income of $100,000.
  • They buy a house valued at $800,000 (assume no deposit).
  • The mortgage rate is 4%, which remains the same throughout the 25 year loan-term.
  • Inflation is very low and wages grow at 2% annually (i.e. 2% real mortgage rate).

Scenario B (low price, high inflation):

  • Buyer has an annual income of $100,000.
  • They buy a house valued at $400,000 (assume no deposit).
  • The mortgage rate is 8%, which remains the same throughout the 25 year loan-term.
  • Inflation is high and wages grow at 6% annually (i.e. 2% real mortgage rate).

The below charts show the repayment schedules for both mortgages:

ScreenHunter_15702 Oct. 26 18.52
ScreenHunter_15701 Oct. 26 18.52

As shown above, a buyer under scenario A ends up with a far higher repayment burden. Why? Because while their initial interest repayment is the same, they are required to repay an extra $400,000 in loan principal over the 25 year term. Hence, halving the mortgage rate does not justify a doubling of home prices.

The situation is even worse when wages growth is taken into account. Periods of high inflation are generally accompanied by high nominal wages growth. And while both scenarios above assume the same real wages growth (2%), the high inflation buyer enjoys much faster nominal wages growth, which effectively inflates away their mortgage balance over time (see next chart).

ScreenHunter_15703 Oct. 26 18.52

After 15 years, Buyer A’s mortgage repayment burden has reduced by only 24% (to 38% of income), whereas for Buyer B it has reduced by 56% (to 16%).

In the final year of the loan, Buyer A’s mortgage repayment burden has reduced by only 38% (to 32%), whereas for Buyer B it has reduced by 75% (to 9%).

In short, low inflation and low nominal wages growth means that a big mortgage taken-out today remains a big mortgage for decades to come.

The second claim that I often hear is that mortgage rates hit 17% in 1989-90, which made housing affordability much worse for the baby boomer generation. In Scott Morrison’s latest housing speech he claimed as much, including the below chart showing that today’s mortgage repayments are way below 1989-90:

ScreenHunter_15700 Oct. 26 18.40

The RBA has previously made similar claims:

ScreenHunter_15699 Oct. 26 18.38

The inherent problem with these types of affordability measures is that they only gauge initial housing payments on new mortgages at the particular moment in time, and not repayments over the full 25 to 30 year loan term.

To highlight why this is nonsensical, consider the below extreme stylised example.

Scenario A (very low price, very high inflation, extreme mortgage rate):

  • Buyer has an annual income of $100,000.
  • They buy a house valued at $300,000, (assume no deposit).
  • The mortgage rate is 17%, which remains the same throughout the 25 year loan-term.
  • Inflation is very high and wages grow at 7% annually (i.e. 10% real mortgage rate).

Scenario B (high price, very low inflation, very low mortgage rate):

  • Has an annual income of $100,000.
  • They buy a house valued at $700,000 (assume no deposit).
  • The mortgage rate is 3.5%, which remains the same throughout the 25 year loan-term.
  • Inflation is low and wages grow at 2% annually (i.e. 1.5% real mortgage rate).

In case you haven’t noticed, Scenario A is a proxy for the late-1980s home buyer, whereas Scenario B is a proxy for today’s home buyer.

It should be noted at the outset that while mortgage rates briefly hit 17% in 1989-90, they did not stay there for long. They have also never been as low as the 3.5% assumed above (see next chart).

ScreenHunter_15708 Oct. 26 19.27

Similarly, real mortgage rates were only 10% briefly throughout the late-1980s and early 1990s (see next chart).

ScreenHunter_15709 Oct. 26 19.30

Nevertheless, even in the extreme example above, the buyer in Scenario A only pays more in mortgage repayments for the first six years (see next chart).

ScreenHunter_15710 Oct. 26 19.42

Thanks to the wonders of high nominal inflation and wages growth (and even in the face of a 10% real mortgage rate), Buyer A’s mortgage debt is inflated away quickly such that their mortgage repayments are:

  • 28% of income after 10 years;
  • 20% of income after 15 years;
  • 14% of income after 20 years; and
  • 10% of income in the final year.

Buyer B is not nearly as lucky, since their repayment burden remains high in the face of low inflation and wages growth, even though they face a ridiculously low real mortgage rate of just 1.5%.  Buyer B’s mortgage repayments are:

  • 35% of income after 10 years;
  • 32% of income after 15 years;
  • 29% of income after 20 years; and
  • 26% of income in the final year.

Coincidentally, today’s home buyer also faces the worst mortgage repayment burden in recorded history. The below table compares the mortgage repayments facing a 2016 buyer of a median priced house against those of the median 1973, 1983, 1993, and 2003 buyer using actual historical data:

ScreenHunter_15714 Oct. 26 19.51

Note that I have used very generous assumptions for the 2016 buyer including a rebound in earnings growth from recent historical lows:

ScreenHunter_15715 Oct. 26 19.52

As well as assuming that mortgage rates crater at 3.5% next year and stay there for the entire life of the loan:

ScreenHunter_15716 Oct. 26 19.54

Even with these generous assumptions, today’s home buyer is facing a much more difficult loan repayment schedule than at any other time in living history due largely to the combination of high home prices, low inflation and low income growth:

ScreenHunter_15711 Oct. 26 19.44

For this reason, beyond all others, commonly used measures of housing affordability – which only consider the size of the initial mortgage repayment on a brand new loan at a particular point in time – should be junked. They massively understate the affordability pressures facing contemporary home buyers.

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Comments

  1. How so very true.

    Atleast with low inflation, i can pile more into cash savings for a house or factory shed without the buying power deflating relative to goods (other than land price).

    I’ll simply wait for house/land prices to crash down and meet me.

  2. These nonsense indices have been central to the marketing of debt to advice dependant clients of banks and other finance institutions. The Nuremberg defence for the FIRE sector.

    Are the contracts voidable, we are going to find out some day

  3. A BIG thank you, to Leith Van Onselen, for doing the definitive analysis on this. I have been arguing this for years, and so have others; but the above analysis is THE classic that needs to be widely syndicated and constantly referred to every time the issue is being discussed in public.

  4. Elizabeth Warren was a Uni professor who got elected to the US Senate on the strength of becoming an internet celebrity for her presentations entitled “the coming collapse of the middle class”.

    Her core point was that vastly increased mortgage burdens, now a norm in some US States, mean that a lot more households will go bankrupt as the result of bad luck. When the mortgage burden has reduced quickly, there is more chance that the household will be able to cope with things like unemployment, accident, disaster, being the victim of a crime, unexpected medical bills, disability of a household member, etc etc. Most households have a bit of bad luck at some stage – now thanks to mortgage burdens, the impact will be far more distressing. Needlessly so.

  5. Tassie TomMEMBER

    Great article!

    One other factor I’d like to add to the article is making extra repayments.

    Let’s assume (to make the numbers easy) that as well as interest, the initial repayments reduce the outstanding capital by 3%. ie: a $500,000 loan at 5% interest will require annual repayments of $40,000 consisting of $25,000 interest and $15,000 capital. I’m talking about P&I loans – not IO loans.

    Now let’s assume that a home buyer could find the extra money to increase their repayments by 20%, so that’s what they do to try to get ahead of their loan.

    When interest rates were 17%, the minimum repayment was 20% of the capital of the loan in the first year (17% interest + 3% capital repayment). By finding an extra 20%, the home buyer has increased their repayments to 24% of the capital of the loan. They therefore manage to pay off 7% of the capital in the first year. If they keep this up for 5 years they will have paid off 35% of the capital of the loan (more actually because of compound interest), reducing their interest burden by over 1/3.

    Now consider that interest rates are 4.5% (again to make the numbers easy) – then the home buyer’s minimum total repayments are only 7.5% of the capital of the loan (4.5% interest + 3% capital). If this home buyer finds an extra 20%, this increases their repayments to 9% of the capital of the loan – 4.5% interest plus 4.5% capital. If they keep this up for 5 years they will have paid off 22.5% of the capital of their loan (again – a little bit more because of compound interest). Their interest burden is still almost 80% of what it started at.

    My point is – now that interest rates are low and capital is high, even if a home buyer tries to break the back of their loan during their “peak earning years”, it is much harder to do.

    • Exactly, another important point. In reality, those light-burden mortgages of the past were not paid off anything like as slowly as the contemporary heavy-burden ones will be; and the ability to repay sooner, is a further reduction in the overall burden.

      When you align the level of the burden with the likely ages of the children in a typical family, and the likely number of them, it tells an even grimmer story. There are going to be kids deprived of all sorts of things at all ages; even in teen years, mum and dad are still going to be struggling and unable to help with music lessons, club fees, sports trip costs, loans of the family car, etc etc.

      • I have a low opinion of parents who over-borrow to the extent you describe, let alone the financial risk they have exposed their family too. Hope the kids are alright when the needful kicks off.

      • Not to mention serious amounts of quality time with Mum (or Dad) that is now a relic of a by-gone age of civilisation when a double income family wasn’t mandatory just to house and feed it.

  6. arthritic kneeMEMBER

    How about Deposit affordability? We often refer to the ratio of average income to average house but what about average income to the 20% deposit on an average house over time? When this blows out and no one can afford it the answer is to decrease the deposit and loosen lending requirements to keep the party going.

    • That is a factor too. The size of the principal has to affect the ability to save the deposit in the first place.

    • Yes, nothing more depressing than when the annual increase in the deposit requirement is more than the amount you’re saving… and when houses are a million and prices are increasing by 15% that’s $15 extra grand..

  7. Is the fractional reserve banking system a problem? When banks can create money (a loan) for free and then lend it out to us suckers at interest. Infinite profits! (aka usury). Add in currency devaluation to deflate the debts and the home owners are now winners too! So much easier the actually working or producing anything. I said it yesterday but this is why Ian Narev is on $12.3 mill and Malcolm Turnbull is only on $517k this year.

    • It is really more about housing supply. Many developing countries have no mortgage credit available at all for most people, and a high proportion of homes are bought with cash saved and family assistance. If it was all about credit, this should result in homes being pretty cheap, but it is quite a norm in such countries for the formal housing market median option to be 8 to 16 times the median income.

      The other outlier example is the dozens of cities in the USA where minimal price inflation happens regardless of how low the interest rates are and how easy the credit is. These cities all have such elastic housing supply by way of suburban expansion, that the price of them is anchored down by competition, just like the price of cars, TV’s, consumer goods etc. Globalisation and trade and competition is the reason that central bankers find it more difficult these days to create traditional inflation in the price of consumption goods; but housing supply can be just as elastic too. It is a matter of political intransigence, if it is not.

  8. I’m not sure how anyone could possibly keep a straight face arguing the old chestnut that it has always been hard buying a home, especially in the 70s, 80s etc, take your pick. It’s just part of that Aussie pissing contest mentality.

    This low rate, low wage growth environment we live in is unquestionably dangerous for households. The real killer is bullshit inflation, where we’re constantly reminded that CPI is bordering deflation, whilst essentials keep rising at 5% per annum plus. That’s put a lid on wage growth, despite real costs rising, debt burdens growing and now by stealth, households are really feeling the pinch but can’t understand why. They’re being told the cost of living is low, so no pay rises, but in reality their budgets are being smashed by their own consumerism and stealth inflation. Now, at the pointy end of the rate cut cycle, there’s nowhere left to go – costs will keep rising, but incomes aren’t keeping up. Will they wake up in time to save themselves (by changing their spending habits)? Nup, our CPI boffins will keep them hoodwinked till such time as the sheriff turns up to take the keys.

    It’s killing marriages and will eventually smash the property market.

  9. Great article. Well done.
    I have never understood why the RBA only focuses on nominal rather than real mortgages rates. I think it started with Luci Ellis as a way of justifying high prices – ie. low nominal rates make it easier to settle on an expensive house because the initial payment is lower as a % of income at the purchase. But that implies that buyers are irrational and driven by money illusion.
    Edit: buyers and lenders

      • And good on you for the fine work mate! It really is the clearest counter to the “We had it tuff back in the 90s too” bullshit I’ve ever seen. This sort of post is why MB is the only site on the net I pay money to read.

      • You can tell you’re not a salesman.

        A value proposition is how you establish trust in an ongoing offer of your product.

        This is the type of ‘free’ offering that would draw many more subscribers.

        On a side note, the mathematician inside me says…

        “What, you’re saying affordability is more a function of Price-to-income that interest rates?”

        Looks like I’m reading here what I’ was saying 3 years ago.

      • “This is the type of ‘free’ offering that would draw many more subscribers”.

        Really? How do you know? We leave loads of good content unlocked. We need to lock up some stuff otherwise why bother subscribing at all?

        “What, you’re saying affordability is more a function of Price-to-income that interest rates?”

        Yes. I have also made that point all along.

      • “Really? How do you know?”

        No one never ‘knows’ when it comes to sales.

        But why I suspect it is because this type of analysis is unique in the Australian media landscape. It’s also a boilerplate for many young people locked out who do not have the gravitas to articulate what is wrong with their situation, and access to this would probably be the first time they could have words match their sense of ‘something is wrong here’.

        You do have a lot of free content sure, but I look at today’s free genres;

        Turnbull/Abbott
        Rod Sims and oligopoly.
        Oldies renting in retirement.

        I don’t think it draws the young, but that’s just me.

        “We leave loads of good content unlocked. We need to lock up some stuff otherwise why bother subscribing at all?”

        That’s not what I am saying. I’m a subscriber, you can check that. My general motive is that anything of value is worth paying for.

        The MB instance is that there is a lot of economic information here that I do have the ability to source, but I have time constraints. In effect, I’m paying for the outsourcing of an entity who provides trustworthy and relevant economic information, that you also have the scale to do effectively…. even though my patience is tested with buggy ad scripts, a 100% price increase in 2 years and a bias appearing in the editorials, particularly through Becker.

        To drive subscriptions, or sales in anything, part of that is to let potential customers know, a value proposition, on what they’re missing out on by not buy/subscribing.

        This is one of your best articles to do so. I also think BB gets it in that it’s the type that would be viral.

        It’s a rejection of reason to assert “this article may be good as a free article” = “every article should be free”

      • “You do have a lot of free content sure, but I look at today’s free genres:”

        You missed the post on housing affordability, which is free and should concern all youngsters.

        Anyway, I’ll regurgitate this post every time The kouk or someone else claims that housing affordability is ok, so there’ll be plenty of opportunity for free content.

      • LOL – Kouk is having a sook right now

        https://twitter.com/pfh007/status/791483972022771712

        He reckons you ignore RBA and Treasury “research”.

        Worth noting that research amounts, in the main, to hand waving and “move along nothing to see” regurgitations sprouted to justify all their bad decisions over the past decade.

        Kouk is such a spruiker for the status quo he should stop slumming with his ALP buddies in opposition and give ScoMo a call as he needs all the spruikers he can get for why we are living in the best of all possible worlds.

      • Ha. Michael Janda wants MB to give the Kouk free access (not really).

        Michael Janda ‏@mikejanda 58m58 minutes ago
        One of the best analyses I’ve read as to why it’s never been harder to buy a first home in Australia http://www.macrobusiness.com.au/2016/10/common-housing-affordability-indices-wrong/ … Paywall warning

        Stephen KoukoulasVerified account
        ‏@TheKouk
        @mikejanda clearly ignoring RBA and Treasury research on the issue … OK….

        Michael Janda ‏@mikejanda 54m54 minutes ago
        @TheKouk Article explains why RBA is wrong. I assumed you would have a subscription given how often @macro_business features your work!

        Stephen Koukoulas ‏@TheKouk 45m45 minutes ago
        @mikejanda @macro_business No I don’t, alas. Maybe I should take out a reverse mortgage and subscribe

        Michael Janda ‏@mikejanda 44m44 minutes ago
        @TheKouk Even though I pay for one myself, I’d be very happy to see @macro_business shout you one Stephen 🙂

  10. scootytootyMEMBER

    Oh my god, I have to listen to boomers spout the ‘mortgages were 17% that one weekend when we couldn’t afford a slab of beer’ argument all the time. This article needs to be open so I can spread it!

  11. This is the sort of article I’d like to share (shove in peoples faces when they bash millennials & talk about how hard they had it) but it’s login protected. Can it be unlocked? I’ll never be able to convince people to read a counter arguments if they have to sign up first.

  12. DarkMatterMEMBER

    There seems to be a very basic problem with the ideas about wages, interest and asset value. If wages remain more or less constant and the asset price (house) goes up while the interest rate goes down to compensate, then the logical conclusion from this is that money in the form of wages cannot possibly be dimensionally equivalent to money as asset value. There is a degree of freedom at play in there. Obviously interest rate sets the relationship, but since interest rate changes to match wages and is a derivative of the asset value, asset value cannot be measured in the same units as wages. The physical equivalent is position and velocity. Position is measured in metres, but trying to measure velocity in metres is meaningless. Velocity is a time derivative of position – so it is measured in metres/sec – a different dimensional unit. How can wages be measured in dollars as well as asset value measured in dollars when they are dimensionally different?

    How do economists explain this? It looks like a basic mathematical error.

    • It’s not equivalent.
      Wages are measured in money at time 0
      Asset prices are measured in money at time 0 plus money t1 + etc. etc.
      The difference in money’s value from one year to the next is the interest rate.
      btw. That’s why the idea of targeting asset prices with interest rates is nonsensical. The interest rate is an asset price.

      • DarkMatterMEMBER

        “Wages are measured in money at time 0
        Asset prices are measured in money at time 0 plus money t1 + etc. etc.”

        That is right. Asset price includes a time component, so it is dimensionally different. Relating it to the static wages value via interest rate ( /dt) is a sleight of hand. What I am saying is that once money becomes part of a dynamic system, patches like that will result in an inability to understand how the system works. I can’t think of any physical system where a property and its time derivative have the same dimension.

        So, I guess my question is – if asset dollars and wages/interest dollars are dimensionally different, why do we call them both dollars?

  13. Brilliant work.

    I wonder what the economic benefit of the hundreds of billions of dollars being poured into buying houses would have done for our economy if it were invested constructively?

    Here you have demonstrated the erroneous housing affordability metrics and the burden of mortgages on today’s home buyer. But what is the collateral damage of this bubble? It must be catastrophic.

    All you need to do now is provide an article debunking the myth that these houses are investments, and the whole bubble mentality will be in tatters; perhaps the bust will do that for you with considerable more punch? 😉

  14. Great post.
    Really tempted to print and bind a few copies to send out as Christmas gifts. For what is better than the gift of knowledge. The lunchroom at work could also do with a few.

  15. Good work!!
    It’s sad that the people that need convincing do understand numbers and they are not stupid, but instead they opted to side with the dark force because that’s how they got to power.. It’s the old story.. I personally lost faith in politicians being able to change course.. there’s too much at stake for them and their backers.. This thing will have to collapse on its own weight.. no one knows when that’s going to happen.. but it will happen eventually..

    There was an article in SMH yesterday about how the US managed to create affordable housing:
    http://www.smh.com.au/comment/scott-morrison-should-look-at-the-us-scheme-that-trumps-australia-on-affordable-housing-20161025-gsarrj.html
    ..The policy, known as the Low Income Housing Tax Credit, offers tax benefits to developers who build apartments rented below market rates. In its thirty years of operation, the credit is estimated to have created about three million affordable dwellings. That’s the equivalent of a city the size of Sydney.
    Remarkably, the credit remains in place today. It has survived five presidents, a political culture that may be descending from dysfunctional to apocalyptic, and continues to cost the US government about $10 billion a year.

    Our housing policies are designed to create and sustain a neo-feudal system instead of creating affordable housing. Let’s face it, it’s not rocket science.. we’re in the era of being able to do gene editing and correct mutations and cure diseases we never thought were curable and we can’t come up with policies so that our citizens can afford a roof over their head? It’s a joke..