Last week we went into a bit of history on housing. Median household incomes in Canada are basically stagnant since 1985 after adjusting for inflation. Inflation caused prices to exactly double since 1985, so a $40,000 income back then would buy the same amount of stuff as our average $80,000 income today. Yet an average house cost $78,000 in 1985 (about $156,000 in 2016 dollars) and they're running over $475,000 across this wide, house-crazed land today.
I believe that over the long run, the average house price should be largely based on the local residents' capacity to pay: a calculation of the median household income and average interest rates. If median incomes go up, house prices should go up long-term. If interest rates drop, house prices should also go up short-term to reflect increased affordability.
In my last post, I explained that the median household income has not grown significantly since 1985 after adjusting for inflation. So we can safely assume that the massive house price increase is not the result of surging household incomes. So why, after the appropriate inflation adjustments, are house prices 3x more expensive today than they were in 1985?
Let's take a look at interest rates.
Mortgage Interest Rates
The rate on a 5 Year Fixed Mortgage is set by bond markets—not your local bank. With some short term blips (and excluding super low rate loans from questionable brokers), there is normally a 2% spread between the Government of Canada 5 year bond rate and the typical Canadian Bank 5 year fixed mortgage rate. This spread is where your bank makes their money.
In 1985, a Government of Canada 5 year bond yielded about 10.5%. Big banks would have offered you a mortgage at around 12.5%. In 2016, the Canada 5 year bond yield sank to 0.6%. Big banks sell you a mortgage at around 2.6%. Mortgage sellers demand a nice, pretty even, more-or-less steady 2% risk spread.
In 1985, at a house price of $78,000 our neon-clothed, teased-hair buyer has scraped together a 20% downpayment. Their mortgage balance on purchase is $62,400. The monthly payment at 12.5% on a 25 year mortgage is $665. (About 20% of her family's 1985 gross monthly income.)
We can tease the numbers out another way by adjusting for inflation. A $156,000 house with 20% down is $124,800 mortgage balance in 2016 dollars. The monthly payment is $1,331 on a 12.5% mortgage. Again, about 20% of average gross family 2016 dollar income of $80,000. In 1985, the average mortgage payment cost 20% of your gross income.
In 2016, our buyer dutifully saves 20% down for a $475,000 house. The $380,000 initial mortgage balance has a monthly payment of $1,721 at 2.6%. Now the payment is 26% of the average family's gross monthly income.
Where did the additional 6% come from to pay that higher housing cost? Probably the future self. Personal savings rates have absolutely collapsed as Canadians have traded real savings and security for stainless steel, asphalt shingles, and chipboard.
In the mid-80s, the typical Canadian household saved nearly 15% of their income. In recent years we're wavering between 4-5% of income. At a 5% savings rate, the average Canadian household will retire with $650,000 after 40 years of saving and investing: if they follow a low-fee, index-based ETF Lazy Portfolio. That will spit off a meagre $32,500 a year following the 20x Rule. Hardly enough for warm winter getaways and summers drinking wine on the Amalfi Coast. Even with Ryanair.
Based on current household incomes, current low interest rates, and 20% down, our house prices should be around $368,000 if we had continued to care about our retirement by saving a decent 15% of our incomes.
What can happen next? Read Part 3 of the series.
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