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Example 1:

Imagine a person making $50,000/year. Divide that by 12 and they earn $4,333/month. Back in July 2000, 22 years ago, the House Price to Income ratio was 4.5, so if you made $50,000 then a house would cost roughly $225,000. Average mortgage interest rates were 8.2%. Assuming you put down 20%, let’s run the numbers for a 30-year fixed rate mortgage. At an 8.2% interest rate, the monthly payment (principal and interest) is $1346. Assuming 1% annual taxes (so $2,250 per year, or $187 per month) and $750 per year for insurance, we are at $1597 for a monthly all-in. Is that affordable? Let’s look at what mortgage brokers use to qualify lenders: monthly housing expenses divided by gross (pretax) income. 1597 / 4333 = 36.8%. This is workable — lenders like to see this so-called “Debt-to-income” ratio as low as possible, but anything under 43% is allowed. If the person has any other debt to consider (student loans, car payment, credit card debt, other mortgages) that also has to be factored in.

Example 2:

Okay, so let’s zoom forward to November 2021 and run the same calculation. Interest rates on 30-year fixed rate mortgages are around 3.1%. Houses have increased in value, both in absolute terms and, more importantly for this calculation, compared to incomes. The Home Price to Income Ratio went up from 4.5 to 7.5, so at the same income of $50,000 the house is now $375,000 but we have the lower rate — so let’s see how it plays out. One note — we now need $75,000 to put down rather than $45,000 before, but let’s assume we find that $30,000 somewhere. Okay:

Hooray, the loan is only $1,281 (principle and interest) so actually cheaper than the other one. I kept the insurance the same, $750/year, and kept the property tax at 1% of value, so $3,750 per year or $312.50 per month. All-in we are at $1,657, so $60 higher than the first example with the lower house price and a higher interest rate. Great! All’s well in the world. Now our debt/income ratio is 38.2% instead of 36.8%, but we can still get a mortgage and get on with our lives.

Example 3:

And how does it look now, 8 months later, with rates at 5.73% (today’s average rate) and Home Price to Income Ratio at 8?

Our house now costs $400,000 and we need another $5,000 to put down (80K total), and just the loan costs $1,863. With taxes and insurance, our all-in is now above $2,000, at $2,259. This represents a 52.1% debt/income ratio, and it’s going to be nearly impossible to get a loan at this amount. Remember, this is pretax, and lenders want you to have some room in your budget for non-housing expenses, like, you know, food.

Links:

https://www.weforum.org/agenda/2019/04/50-years-of-us-wages-in-one-chart (mentioned)

https://www.numbeo.com/property-investment/rankings_by_country.jsp?title=2022-mid&displayColumn=0

https://www.longtermtrends.net/home-price-median-annual-income-ratio/

https://fred.stlouisfed.org/series/MORTGAGE30US

https://www.cnbc.com/2022/06/30/housing-shortage-starts-easing-as-listings-surge-in-june.html