Buying within your means

THE ARTICLE WAS FIRST PUBLISHED ON THE STRAITS TIMES

4th August 2010

By Tilak Abeysinhe and Gu Jiaying

IN THE rush to secure a home amid esca­lat­ing prop­erty prices, first-time home­buy­ers, espe­cially young adults, may inad­ver­tently com­mit them­selves to prop­er­ties beyond their means.

Since mort­gage pay­ments and other home bills take pri­or­ity over other basic neces­si­ties, ris­ing mort­gage rates may push some home­buy­ers to suf­fer a housing-induced fall in their stan­dards of liv­ing. It is impor­tant, thus, to take a long-term per­spec­tive on hous­ing affordability.

Afford­abil­ity is usu­ally mea­sured by the ratio of monthly mort­gage pay­ment to cur­rent monthly house­hold income. In the United States, if this ratio is less than 30 per cent it is assumed that the prop­erty is afford­able. In Sin­ga­pore, a cut-off ratio of 40 per cent is one of the cri­te­ria banks use to decide on home loans.

How­ever, this is not a good mea­sure of afford­abil­ity for two rea­sons. First, by extend­ing the amor­ti­sa­tion period, monthly mort­gage pay­ment can be reduced. This can give the impres­sion that afford­abil­ity has improved, although the total inter­est bur­den has gone up. Sec­ond, the mea­sure essen­tially focuses on short-run hous­ing afford­abil­ity by using cur­rent income instead of an esti­mate of per­ma­nent income. Undue reliance on short-run hous­ing afford­abil­ity mea­sure­ments was one of the trig­gers in the US sub-prime mort­gage crisis.

A much bet­ter indi­ca­tor of hous­ing afford­abil­ity is the ratio of house price to life­time income — house price being the dis­counted present value of future mort­gage pay­ments. Life­time income can also be worked out as a dis­counted present value of the future income stream, using the same mort­gage rate.

(For exam­ple, if the annual inter­est rate is 5 per cent, the dis­counted present value of $105 one will receive next year is $100. Alter­na­tively, if one saves $100 today at the 5 per cent inter­est rate, one will receive $105 next year.)

Under some con­di­tions, the two ratios — mort­gage pay­ment to per­ma­nent income, and house price to life­time income — are the same. We can thus use a cut-off ratio like 30 per cent to define an afford­abil­ity limit. We have not worked out an opti­mal cut-off value for Sin­ga­pore yet.

CLICK HERE FOR THE SCANNED TABLE PDF FILE

NOTE: I HAVE SCANNED AND PUT UP AN ATTACHMENT OF THE TABLE (TO ROUGHLY MEASURE THE AFFORDABILITY OF BUYING A HOUSE BASED ON YOUR INCOME) FOR YOUR CONVENIENCE.

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Home­buy­ers know the prices of the houses they want and the trans­ac­tion costs involved. What they need is an esti­mate of their life­time income — that is, their accu­mu­lated sav­ings plus the dis­counted present value (DPV) of their earn­ings, over their remain­ing work­ing life.

Using sur­vey data col­lected by the Depart­ment of Sta­tis­tics, we can deci­pher pre­dicted income pro­files by birth cohorts for dif­fer­ent income groups over the work­ing ages of 20–64. We now have data only for three income lev­els: lower (25th), mid­dle (50th) and upper (75th ) percentiles.

Since our focus is on young home­buy­ers, the accom­pa­ny­ing table presents esti­mates of the DPV of house­hold income for house­holds headed by 30-year-olds. By adding their own accu­mu­lated sav­ings to the income fig­ures, young home­buy­ers can obtain an esti­mate of their life­time income. They can then divide the price (includ­ing the trans­ac­tion cost) of the home they are buy­ing by their esti­mated life­time income to see what per­cent­age of their life­time income will be con­sumed by the property.

The rest of the table pro­vides illus­tra­tive com­pu­ta­tions of hous­ing afford­abil­ity for the three income group ref­er­ences. Accu­mu­lated sav­ings (includ­ing inter­est earn­ings) were esti­mated from house­hold expen­di­ture sur­vey data, and trans­ac­tion costs were esti­mated using cur­rent rates on stamp duties and other fees and charges. Prop­erty taxes and costs of home insur­ance and main­te­nance were not included.

Some gen­eral obser­va­tions that emerge from this table are worth highlighting:

First, when the mort­gage rate goes up, home­buy­ers have to spend a higher per­cent­age of their life­time income on hous­ing, and afford­abil­ity goes down.

Sec­ond, given that cur­rent mort­gage rates are above 5 per cent, and if we use the 30 per cent cut-off rule, HDB resale flats of four rooms and above are not that afford­able for low-income groups.

Third, at cur­rent mort­gage rates, HDB resale flats are well within the afford­able range for mid­dle– and upper-income groups.

Fourth, pri­vate prop­er­ties are obvi­ously for high-income groups. Still, even for those in the 75th income per­centile, pri­vate res­i­den­tial prop­er­ties at median prices are not within the afford­able range at cur­rent mort­gage rates.

Tilak Abeysinghe is deputy direc­tor of the Sin­ga­pore Cen­tre for Applied and Pol­icy Eco­nom­ics, National Uni­ver­sity of Sin­ga­pore. Gu Jiay­ing is pur­su­ing a PhD at the Uni­ver­sity of Illi­nois at Urbana-Champaign.

Tags: buying a home, buying a house, income, mortgage, retirement, retirement planner, retirement planning