Interest rates in nominal terms are at 20 year lows. They are also very low in real terms by historical standards, but the nominal interest rate is probably more relevant, since it determines the cash flows of borrowers.
Figure 1.8 shows that since the mid 1990s, there has been only a slight increase in mortgage interest payments as a share of disposable income, and no increase in the share of total interest payments.
Figure 1.9 shows that households’ borrowing capacity — based on earnings and required repayments for a 25 year loan — track very closely with house prices. Households have taken advantage of low interest rates and higher incomes to borrow more and house prices have been bid up as a result. Over the past 12 years, average incomes have risen by 63 per cent while the mortgage rate has fallen by about half. As a result, the borrowing capacity of an average-income household has risen by nearly 175 per cent. This increase in ‘purchasing power’ has been capitalised into prices.
Seen in this light, house prices have not been caused by a bubble. They have been caused by fundamental factors that should determine house prices. The decrease in interest rates should be thought of as a once-off, structural fall in the level of interest rates that has been associated with a once-off, structural increase in the price of houses. Since interest rates have reached their low point, it is to be expected that house prices have reached a high point, and from now on, will be determined by the balance of supply and demand forces, with the latter mainly a function of income and population growth.
Moreover, if affordability is defined as the ratio of house prices to borrowing capacity, then affordability has remained (more or less) unchanged over the period since 1985, as shown in Figure 1.9. That said the price line has crept a bit above the borrowing capacity line, indicating that borrowing capacity has begun to fall somewhat behind prices. Looking forward, if interest rates rise due to cyclical economic factors, borrowing capacity for the average home buyer will fall. But this should lead to a fall in housing prices. Affordability for the average homebuyer should be largely unaffected.
However, the situation for first home buyers is different from the average home buyer because they need to be able to gain initial access to mortgage finance, and to do this they need (in most circumstances) a deposit. The following chapter discusses measures to increase affordability for first home buyers.