Is Housing Really More Affordable?

Housing affordability indexes have been published recently showing that even with higher interest rates homes are 10% more affordable than in 1994 when interest rates increased a lot. However any comparison of affordability before 2009 is dubious and unreliable because of the use of Easy Qualifier loans from 1984-2009. These loans allowed borrowers to use stated income so that if a borrower had enough current income to qualify but didn’t have that income consistently for the past two years then he couldn’t qualify for the loan under current “fully documented income” rules, but he could qualify under the old method. So even if houses are still allegedly affordable there may be a significant number of borrowers who can’t qualify.

The dichotomy is caused by the fact that loan qualification rules define income more cautiously than income per IRS regulations because lenders take a two year average of variable income, so they may disregard the amount of income on a tax return. Thus it is possible that borrowers, collectively speaking, are already maxed out on their ability to borrow.

The way that a financially successful borrower can still be told by the bank that he can’t qualify could be:

1. A secondary part time job might not be counted unless the borrower held both jobs for two years with no employment gaps,

2. Overtime pay, employee stock option bonuses, etc. also need a smooth, stable two year history;

3. Self-employment income also needs a smooth, stable two year history

4. Rookie would-be landlords can’t use rental income until they have owned a rental property with the rent posted on the income tax returns

5. Retired people living off of investments may be required to use a three year income average and if the income has been going down (for example, due to declining interest rates) then the entire amount of variable income can be difficult for the bank to use, as they prefer stable or rising income.

If a married couple earned 80% of their income from one person’s base salary and 20% from the other person’s self-employment income but the self-employment income was unstable then they couldn’t use their full income to qualify and might have to buy a property that was 20% cheaper than what an affordability index implies. Or what if someone got 20% of income from overtime and 80% from base pay but due to job hopping and economic cycles the two year average was unable to verify the sustainability of the variable income.

Further complicating this is that in previous decades more people worked for a salary and now more people are self-employed independent contractors. The economy needs the work force to absorb the risk of layoffs by working as an independent contractor. However, this results in a less reliable source of income according to banking rules even though there may be adequate income as defined by the tax code in some years. The banks are justified in their fear of people with variable types of income because it is important for underwriters and stock market analysts to adjust or discount income to filter out unsustainable temporary windfalls from reliable cash flows. The way investors hurt themselves is to take income at face value and not filter for sustainability.

Thus housing market analysts and investors should not leap to conclusions that all is well in the housing market because of the ratio of the cost to buy divided by the borrower’s nominal current tax code income. In a way, society is poorer off when society’s income is derived through excessively risky, unsustainable cash flows. Therefor a macroeconomic analysis of housing needs to adjust for the hidden problems with measuring sustainable income.

To properly measure affordability one would need a long-term study where a list of people with very conservative types of employment (where there is only base pay and nothing else) such as civil service employees were followed for the past 30 years and see how affordable housing is for them based on fluctuations in income, interest rates and home prices. I have not heard of any studies like that. Based on trends in the last 30 years it seems people are migrating away from safe, stable employment and are moving into more risky types of income earning methods. Thus even a longitudinal study of civil servants’ home purchases might not clearly answer the question what is the true rate of home purchase affordability? Additionally, besides income tests, banks have stricter tests regarding down payment (and its verification that it is truly the borrower’s own unborrowed funds), and credit rating. These non-income tests are another reason why today’s affordability indexes have dubious comparison with the past.

Despite my caution about the affordability index there is still a chance that homes could go up because I expect a modest labor boom so that wages will rise. During a labor boom employers may hire some former independent contractors as traditional employees, thus solving the employee’s need to qualify for a loan. If someone gets a salaried job and they used to be self-employed sometimes the bank allows full recognition of income with only a short time on the job, but it doesn’t work if one goes from salary to self-employment! When interest rates rise the curvilinear nature of amortization tables makes the payment increase less steep than one would expect. For example, when rates are 14% almost all of the payment is interest, when they are 4% then 31% of the payment is principal, plus the property tax and insurance is the same.

Investors should seek independent financial advice about how to carefully measure sustainable cash flows, which are the key to investment valuation. I wrote an article “Best way to forecast real estate”.

About the author

Don Martin, CFP®

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