Interesting analysis of affordability

Turnbull2000

This is not an article, but a post from the excellent Fool.co.uk forums.

http://boards.fool.co.uk/Message.asp?mid=10871488&bid=51402&sort=whole#10872650

Credit to 'globalarbtrader'

Revisiting lifetime affordability

One metric that is interesting to calculate and hasn’t been updated for a while is the “lifetime” cost of housing. Depending on when you bought, the average amount of your wages you handed over in mortgage payments will have been radically different. This measure is interesting, because if the lifetime cost of housing is higher then:

a) There will be less money available for other consumption since the price of the housing good has increased.
b) Alternatively if the money spent on housing stays constant it will be harder to “move up” the housing ladder, since this is only possible if the proportion of your income going on mortgage payments drops to a level where you can then take on more debt (the housing ladder also depends on the evolution of house prices relative to income)

Given that the advantages and shortcomings of this calculation have been discussed at length I will not bother talking about them – just assume I know them already, so I will just state what assumptions I make (of course you can question these, but then any exercise of this type is sensitive to them and I had to make some assumptions). In each of the years below a first time buyer on average wages buys an average house, handing over six months gross wages as a deposit. They then pay the average mortgage rate (something like a tracker then) over that period. Each year we work out what proportion of their income is going on interest payments. This will depend on current interest rates and their current wage.

Clearly the lifetime cost will depend on the evolution of interest rates and wages. For the future I use 4% wage inflation (roughly the average since the ERM crisis and close to where it is now) and 5.9% mortgage rates (a little below where they are now; basically the average level since the BoE was made independent).

In the table below the columns are: initial Loan to Wages ratio (i.e. HPER minus 0.5), initial payment as % of wages (“initial affordability”), and the average payment over 25 years

As is well known HPER ratios are higher than ever before but rates are lower (with the exception of the pre-1960’s period). It is fairly obvious that current initial affordability then is high; but not as high as eithier 1979 or 1989. However the borrower in 1979, and to a lesser extent 1989 benefitted from interest rates that fell quite quickly over the period concerned and higher levels of wage inflation.

Although 1959 was the best time to buy (benefiting from subsequent wage inflation and negative real rates in the 1970’s and a very low initial HPER) and 1969 wasn’t bad; it was roughly equivalent to buy in 1979 as in 1997; although the HPER ratio was slightly higher interest rates were lower, and the subsequent path of falling interest rates compensates for the lower wage inflation. The worst times to buy overall then are 1989, with the current period 2007 actually worse.

Buying in 1989 although you initially suffer from very high interest rates, these quickly fall and halve in 10 years; it is fairly unlikely that rates will half from here onwards. At the same time you benefit from 18 years of wage inflation that are higher than the current level (7.6% compared to 4% from now on). Thus while initial affordability looks much worse in practice your mortgage costs will drop; the FTB who bought in 1989 is now paying 10.8% of their wages on the original mortgage, but in 2025 todays FTB’er will still be paying 17.6%.

As is well known on this board then the housing ladder prospects for someone who bought last year are actually worse than any previous generation. Indeed since the housing ladder to a degree was an artifact of conditions that are unlikely to be repeated (initial low HPER ratios followed by wage inflation with negative real interest rates, and then falling nominal rates; for those who bought in the 1960’s,1970’s and early 1980’s) things look bleak – people will in the future have to spend a lot more on housing to get the same utility as their parents; unless prices fall significantly.

(Those who bought in 1997 did not have a ladder effect eithier because prices have subsequently increased much more than wages – so although their lifetime cost of housing is quite low the cost additional of moving up exceeds the gains made here, but this is outside of the scope of this discussion).

For interest for the two periods (1989 and 2007) to be equivalent interest rates would have to be around 70bp lower or wage inflation 1% higher; so roughly speaking real interest rates need to be around 70-100bp lower than the assumed level of 1.9%; they have only been at that level in one year (2004) so I feel this is unlikely.
Avg mortgage rate / HPER less deposit / Initial payment / 25 yr avg
1959 5.5 2.5 14.0% 9.1%
1969 8.5 2.7 23.0% 8.8%
1979 11.9 3.1 36.7% 14.3%
1989 14.4 4.4 63.6% 20.4%
1999 6.5 3.6 23.2% 13.3%
2007 6.1 5.8 35.4% 22.3%