Friday, September 26, 2014

Why Serviceability ≠ Affordability (Australian Property)

Still today I see many commentators using the terms serviceability and affordability interchangeably in relation to Australian property. The most recent occasion I noticed was in a post from David Bassanese a week ago where he wrote:
A better measure of house price valuations – which at least allows for the structural change in interest rates over time, though not financial deregulation – is mortgage affordability.  As seen in the chart below, there has been no obvious structural worsening in mortgage affordability over recent decades. Assuming a 20% deposit, loan repayments to purchase the median-priced Australian house have averaged just over 30 per cent of average household disposable income since at least the mid-1980s.
And posted the following chart to support his assertion:
It shows that initial loan repayments on a median-priced house have remained fairly stable over time (as a percentage of household disposable income). The chart and commentary suggests that "affordability" was the same in the early 1990s as it is today (we have higher prices relative to income, but interest rates are lower), let's compare an example using figures between the two periods to see if affordability really is the same.
Based on Bassanese's house price to income ratio:

The ratio was around 3.5x in 1992 and 5.5x today. Keep in mind that other commentators who calculate these ratios use different methods, so while the ratio might change around a bit, the change between historical ratios and those today should be similar in a single set/series of numbers. Let's do the sums.
With a household on $100k. They save their deposit at a rate of 20% gross income and repay the loan at a fixed amount of $3,500 per month (using this mortgage calculator & interest rates from here to get my numbers below).
1992 Numbers: $350,000 purchase price (3.5x income)
Deposit (20%): $70,000. 3.5 years to save.
Interest rate: 11%
Loan amount: $280,000
Repayment: Loan is repaid in 12 years, 1 months. Total paid, $506,980.
2014 Numbers: $550,000 purchase price (5.5x income)
Deposit (20%): $110,000. 5.5 years to save.
Interest rate: 5.5%
Loan amount: $440,000
Repayment: Loan is repaid in 15 years, 8 months. Total paid, $657,061.
So even if interest rates had remained elevated the entire period of the loan, it still ends up more affordable over the long run to have double the interest rate, but lower price to income ratio. Not only that but it would be faster to save the deposit given that it's a lower amount (relative to income) and I haven't taken into account the higher interest rate on saving for the deposit which would have benefited the 1992 scenario. Costs such as stamp duty which are tied to the price paid would be lower too. Finally, higher interest rates tend to come with a higher rate of inflation, so the real value of the debt would be reduced faster as wages increased, meaning the buyer in 1992 would have found it easier to ramp up the level of repayment.
As I have mentioned in the past on housing affordability, I prefer the following basis as a definition for affordability:
"Afford: To manage or bear without disadvantage or risk to oneself."

It's clear that although initial loan serviceability might be similar with lower rates and higher prices, the buyer is also at a clear disadvantage over the term of the loan.
When considering affordability we need to take a holistic approach and not use a simple snapshot of a single repayment as the basis to make judgement calls on whether house prices or a mortgage used to purchase them is affordable. A mortgage is a long term commitment and shouldn't be treated so trivially by market commentators.

I'm sharing links and opinions daily on Twitter (@BullionBaron).


 Buy bullion online - quickly, safely and at low prices