This article first appeared in the Adelaide Review at this link: 


Any analysis that does not take account of the level of interest rates in the measurement of housing affordability is flawed.

In a very simple stylised example, is a $500,000 house with a $400,000 mortgage more affordable if the mortgage interest rate is five percent or eight percent?

The answer is, of course, rather straightforward. The annual interest cost with a five percent mortgage interest rate is $20,000 while an eight percent interest rate sees the annual interest payments jump to $32,000. That $12,000 a year difference is substantial and is clearly a factor when potential borrowers are looking to take out a loan. Blind Freddie can see that a decision to borrow money and buy a house is hugely enhanced in a low interest rate climate versus one where interest rates are high.

Those who exclude interest rates for their assessments of housing affordability do so on the truism that interest rates will likely change over the course of a 25-year mortgage. At the present time, when interest rates are skating at a record low, the general premise is that interest rates will on average be higher than today.

This seems a fair assumption, but given the forecasting record of most analysts, it is far from certain that interest rates will be much higher than today, if at all, for many years to come. Indeed, some of those with the loudest and shrillest voices on affordability were, just a few years ago, forecasting official interest rates more than double what they are today. And if interest rates do go up in time, it is likely that house price growth will moderate as affordability deteriorates.

The analysis of affordability also often ignores the affordability-enhancing effect of household income growth. Most people have higher incomes over time, in part through regular pay increases and through promotions and more responsibility as they gain experience and expertise.

Even in the current economic climate of entrenched sub-trend growth and an associated weak labour market, household disposable income growth is rising at around four per cent per annum. Unless there is a recession or something similar in Australia in the next few years, household income growth is likely to rise by a similar four percent annual pace for many years to come.

Assuming in the example above, the household disposable income of those taking out the $400,000 mortgage on the $500,000 house was $100,000 when the purchase was made, five years from now, the annual income of that household is likely to be in the order of $120,000.

So, even if none of the $400,000 initial loan has been paid off, and that house price growth has been zero, the metrics concerning the debt level and value of the house has improved. It is obvious that if some principle has been paid off the loan and house prices are up even marginally, the dynamics of affordability have been greatly enhanced for those buying the house.

It has never been particularly easy to buy a house. It certainly isn’t now; it wasn’t eight years ago when prices were 30 percent lower. That is because back then interest rates were five percentage points higher than now and household incomes were some 35 percent lower.

Nor was it easy 25 and more years ago when the targets of today’s “affordability extremists” target Generation X for buying houses cheaply.

Sure, house prices were some 65 percent cheaper than today, but interest rates were entrenched in double digits, household incomes were less than half what they are today and unemployment persistently stuck in a seven to 11 percent range made it hard to get that great, high paying job needed to earn the income needed to buy that ‘cheap’ house.

Housing affordability is an emotive issue with many people feeling squeezed out of the market focusing on the price and difficulty needed to get a sufficient deposit. What they overlook is the level of interest rates, the ease at finding a high paying job when the unemployment rate is six per cent, and the surge in household income growth.

Buying a house to live in has been a great investment for the vast bulk of Australians over many decades. It probably still is even though prices in Sydney and parts of Melbourne are ridiculously high.

The Reserve Bank of Australia is aware of this and this is why it has not been panicked into implementing any silly policies aimed at crimping house price growth. Indeed, the RBA noted in its most recent comments on the issue, “housing ‘affordability’, measured as the share of average household income required to service a loan on a median-priced dwelling, has continued to cycle between 20 and 30 per cent, and is currently well below previous peaks”.

That says it all.