By Lachman Balani
TORONTO: As requested by many readers and subscribers, I am writing this as a follow-up to my article on why there is no housing crash in sight for Toronto, which was well received on many forums prompting many discussions in favour and against, and also published in hard copy form in the mainstream Canadian magazine- Exempt Market Watch.
Using another metric, namely the affordability or non-affordability issue of homes at their current levels- many people claim that incomes have not kept pace with house prices, therefore affordability is dwindling.
However using the Bank of Canada 2011-2012 winter study on affordability (measure) we see that the formula they use still shows homes are affordable.
The affordability measure (AFF) is defined as the ratio of monthly mortgage payments to disposable income (DI).
The monthly payment depends on the mortgage rate r; the maximum amortization period in months N; and the total value of the mortgage M. For example, with a 95 per cent loan-to-value ratio (or 5% down payment), the mortgage size M is equal to 0.95 x P, where P is the purchase price of the average house. An increase in the AFF ratio indicates a decrease in affordability (inverse relation). Higher house prices and interest rates lower affordability, while a higher income (DI) and a longer amortization period increase affordability and improve access to mortgage financing.
Below is a chart showing the affordability ratio- remember, the lower the ratio the more affordable the home.
(Note: This measure estimates the size of mortgage payments for a first-time homebuyer, given prevailing interest rates and house prices, and then scales this value by personal disposable income. A higher value of this ratio represents lower affordability)
As we can clearly see, from 1986 to 1990 the affordability of homes was very low and then started improving until 1994 and worsened slightly for a year or so and then strengthened again. Since 1996 housing has been very affordable for Canadians. In 2006, when amortization periods were lengthened from 25 years to 40 years, we see that housing became even more affordable. About 4 years ago, when the government started to tighten mortgage rules we see homes becoming less affordable but last year there is a dip in the ratio which prompted the government to again tighten rules in July. However despite the tightening, pundits say housing is still affordable for first time home buyers and when the new figures come out, the ratio will still be in line with the historical average of about 0.3 (broken straight line across graph). Homes, according to these analysts, are still affordable mainly due to the prevailing low interest rates.
Skeptics tend to say that when interest rates rise in a year or so (who knows if that will happen), those on variable rates will not be able to afford the rise in their mortgage payments leading to serious issues in default rates. However, we must keep in mind that in the last several years variable rates have been given to those who passed the stress test of being able to afford it at the 5 year posted rate of between 5.24% – 5.49%. So those with a variable rate of prime – 0.75% (as was the norm), or 2.25% currently, need to see a rise of approximately 3% in interest rates for them not to be able to afford their mortgages. A quick rapid rise of 3% is not foreseen and when rates do rise, those on variable rate mortgages can definitely lock into fixed rates which will still be lower than the average 5.39% used to qualify them.
However there is a caveat here, in certain pockets and areas, housing may be out of reach for certain people, but in general all over Canada housing is still affordable and that is what the government looks at.
Again, I wish to stress that like the other article where the metric of price was used to determine whether we will see a crash or not, this one examines the situation from the angle of affordability alone.
To read the first article- please go to http://newseastwest.com/no-real-estate-crash-in-toronto-in-sight-2/