Stock photo licensed from iStockphoto.com

Affordability: Income vs. Interest Rates

Posted July 26th, 2010 under say what?, smart buying, smart selling.

(This is article #3 of 6 in a series about the factors that influence the selling price of your home. For the first two articles, see the 'Smart Selling' section of my site.)

Affordability is the relationship between income and interest rates: the higher a person's income and the lower the current rates, the more they can afford to pay for a home.

Affordability doesn't directly influence the selling price of your home. Instead, it influences the level of demand (the number of people who can afford your home), which, as we saw last month, influences the final selling price.

Let's look at an example. At a 5% interest rate, a person with an annual gross income of $50,000 could get a mortgage loan of about $185,000. Add a down payment of $10,000 and this person would be in the market for a home priced around $195,000.

Say the banks lower the interest rate to 4.5%. That same person with the gross income of $50,000 can now afford prices up to $205,000.

However, there is a side effect. Because more people can afford the $205,000 home, the demand has increased, and the final selling price will likely be higher.

Of course, if interest rates remain the same but the average income increases, the same effect occurs. In other words, affordability is also influenced by the job market.

So, how do you take advantage of changes in affordability? If you're selling but not buying (for example, if you're moving into a rental), you should aim to sell when affordability is high. This will allow you to take advantage of increased demand.

If you're buying, high affordability can give you access to higher-priced homes, but you need to be careful. If you commit to a mortgage at the upper limit of what you can afford when rates are low, you risk losing your home if rates go up. (This behaviour contributed to the recent housing collapse in the United States.) Always leave a buffer in case rates go up—your agent can advise you on an appropriate amount.

Check back for the next article in this series, when I discuss everyone's favourite influence on market price: location.

Want to know more about affordability? Just ask me, I'll be happy to help.

--Peter

Get monthly real estate advice in your inbox, free! privacy policy