Housing Affordability in Three Dimensions: Price, Income and Interest Rates

Abstract

While the Dream of homeownership can be traced back to the homesteading spirit of the pioneers, today, the possibility for many American households of achieving that dream is precariously balanced on a tripod of price, income and interest rates. The current demand for has put upward pressure on prices, creating a situation were home price growth is currently outpacing income growth. Yet the potential for a reduction of affordability is being offset by historically low mortgage interest rates, which are currently favorable to affordability. Issues affecting affordability - critical to broad-based home ownership - particularly affect minority groups. The most stable of the three dimensions currently seems to be mortgage interest rates, which are low and moving in a direction favorable to affordability. Affordability is a public policy target that moves in three-dimensional space measured by home prices, household income and mortgage interest rates. Analyzing it from the dimensions of home prices and income, affordability is near record lows as the ratio of home prices to income is currently at 4.14, close to the maximum of 4.19 reached in 1988. The ratio had declined to 3.90 by 1992 and ever since, it has risen steadily to today's level. For many, this high ratio brings another comparison to mind - that of a housing bubble. If prices rise too fast, fewer Americans will be able to afford a home. The concern then becomes that the resulting reduction in demand will allow home prices to bust. Dramatic changes in demand, however, are not likely to occur in the broad national market, but rather in regional markets where the availability of employment tends to fluctuate more dramatically. The important difference between today's market and that of the 1980s is that mortgage interest rates are at 6.50 percent and falling, compared to 10.25 percent in 1988. Therefore, when this third dimension is incorporated, we find that the ratio of mortgage payment to income at the median is currently 32.4 percent, compared to 40.5 percent in 1988. This lower payment ratio is largely the result of lower interest rates, but it is also being affected by the recent increase in the income growth rate. In June 2002, personal income grew by 0.6 percent, the highest rate in two years. Since interest rates are not expected to rise in the near future, and income is experiencing strong growth, the demand that supports the current prices can be expected to remain stable for the near term. That's good news for the market in generally, but particularly for those interested in affordability