Friday, July 23, 2010

Housing Affordability 1971-2009: Interest Rates and Borrowing Capacity

This post is part of the series Housing Affordability 1971-2009

We'll begin the series by talking about interest rates and borrowing capacity. If you are already familiar with the subject, this may not be of interest to you as the discussion will be a bit basic. There will be more interesting things in the future, I promise.

For purchases that are as large and have as little equity as most home purchases, the effect of interest rates is very large. For example, a $100 monthly payment at the current rates of 4.4% could buy a $22,188 home assuming a 10% down-payment. The same monthly payment at 18.45%, last seen in October 1981, could only buy a $7,197 home assuming the same 10% down-payment; that's about a third of the purchasing capacity. While I picked the most extreme points in the data-set, the example serves its purpose. For this same reason, it is useless to talk about home prices without also talking about interest rates, as affordability is measured in the monthly payment, not total cost, for most people. With mortgage rates at historic lows, the buying capacity of a monthly payment is the most it has ever been. Furthermore, if deflationary pressures and extremely loose monetary policy don't cease, we could see that capacity increase even more, since purchasing capacity increases at an increasing rate as interest rates drop, as you can see below (click for larger image).

To better realize the effect of interest rates on mortgage borrowing capacity though, it makes more sense to look at them both in a time line. As you can see below, the buying capacity of $500 has varied very widely over the last 40 years, although it has increased dramatically since 1981, when interest rates began a 30-year decline after Paul Volcker's Fed began aggressively fighting inflation in 1979. Please note that the purchasing power of a $500 monthly payment number assumes a 10% down-payment.

That's all for this introductory post. In the next post I'll address how buying capacity has changed with respect to both interest rates and wages, and how declining interest rates have allowed for an increasing standard of living even as wages have grown at a slower pace than home prices.


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