Seattle Times business reporter Eric Pryne quoted me yesterday in his article about the affordability index, and as I was reading through the comments posted at the Seattle Times website, I noticed an awful lot of misconceptions about what the affordability index is, and what it tells us. So, I thought maybe it would be a good time for a bit of an in-depth course on the concepts behind the affordability index.
Any time you attempt to simplify a complex concept into a single number, it is important to recognize the assumptions that go into calculating that number. Whether we are discussing the affordability index, the Case-Shiller home price index, or even the UV index, full understanding is crucial to a constructive conversation.
To kick things off, here’s King County’s quarterly affordability index back through 1993, the furthest back NWMLS median home price data is available, so we can all get a visual of the data that we’re discussing.
What the Affordability Index Is
In short, the affordability index is a simple measure that shows the relationship between median home prices, median household incomes, and interest rates. It is useful merely as one tool of many in gauging the overall health of a given housing market.
It is calculated by determining the monthly payment (principal and interest) that would result from buying the median-priced home, assuming a 20% down payment and current interest rates on a 30-year fixed-rate mortgage, then comparing that to 30%* of the monthly median household income (the standard measure of “affordable housing”). Note that the median household income is merely the mid-point taken from a sample of all households in the county, whether they are one person households or ten person households.
An affordability index of 100 means that a hypothetical household earning the median household income would pay exactly 30% of their monthly income toward the principal and interest of a mortgage on the median-priced house if they bought today with 20% down using a 30-year mortgage at prevailing interest rates. Above 100 is more affordable, while below 100 is less affordable.
What the Affordability Index Is Not
The affordability index is not intended to tell you whether or not you can afford a specific house in your specific financial situation. It is not a tool for determining the value of a specific house. It should not be used as a sole signal of when it is or is not a “good time to buy.”
Interest rates are used in calculating the affordability index, but the availability of financing is not a factor in the calculation. There is no easy way to quantify the fact that in 2005 anyone who could “fog a mirror” could waltz into a $400,000 loan, while today the standards are much stricter.
The historic standard for “affordable housing” is that a household not spend more than 30% of their gross income on total housing expenses. Note that when we calculate the affordability index we are only taking into account the principal and interest payment on the mortgage. The affordability index does not include the expense of taxes, insurance, maintenance, or any sort of home owners’ association dues.
It is also important to note that with respect to down payments, the affordability index simply assumes 20% down, and leaves it at that. Obviously very few people have 20% of the median home price saved up in cash sitting in a bank account to be used as a down payment. With the median single-family home priced at $384,000 in King County as of July, that would be $76,800. I would not be surprised if the majority of families do not even have one tenth that amount saved. However, you have to assume something, and if you assume less than 20% the equation would become much more complicated with PMI or piggy-back loans.
The affordability index also does not take into account an area’s jobless rate. An affordability index of 100 does not mean that a majority of households can now afford to buy a house, because it does not factor in unemployment, savings, or credit scores.
Conclusion
Some of the commenters on the Seattle Times article seemed to be extremely frustrated, decrying the article as “lies and inflated information,” or “propaganda.” This is somewhat understandable given the claim in the headline that the Typical King County family can again afford median-priced house (although I doubt Eric was the one that wrote that headline). However, the article itself stuck to the facts: King County’s affordability index has indeed recovered in recent months, thanks to a combination of falling home prices and falling interest rates.
Most of the anger in the comment section seemed to stem from a misunderstanding of what the affordability index actually is. Unfortunately, one of the downsides of the newspaper format is that they are not usually able to delve into a subject like this in depth to the degree that would be necessary to fully explain the underlying concepts to every reader. Hopefully this post is able to fill that hole for some of the confused and upset readers out there.
Additional Resources
- Long-term affordability index back through 1950
- Simple Affordability Calculator
- Additional posts on the subject of affordability
Data Sources
- Median Single-Family Home Price: Northwest Multiple Listing Service
- Median Household Income: Washington State Office of Financial Management
- Interest Rates: United States Federal Reserve
*The Seattle Times article says that the WCRER uses 25% of income in their calculations, but I have always used 30% as it is the more standard measure of “affordable” and my calculations tend to match pretty closely to theirs.
Headlines seem to be a problem at all newspapers.
I think, but I’m not positive, that you’re missing the mark on your financing comments. Yes, financing is tougher to get for some people, and for just about everyone what they’ll loan for a given income level is less, but I would suspect that what the banks will loan is still more than the 30% figure used by the affordability index. I bother mortgage brokers with too many questions as it is, or I’d ask one. But historically banks have always been willing to loan more than you should be willing to borrow, it’s just that now it’s not much, much more than you should be willing to borrow. So anyway, I don’t see how financing changes even fits into this, other than reduced borrowing ability is one factor that sent prices down.
Ideally someone buying shouldn’t be making a decision on how much they’ll pay for a house, or what price range they’ll be looking in, based on how much a bank is willing to lend. Instead it should be based on how much they are able to pay each month, and then apply that to a type of loan they can get that isn’t too exotic (which right now would be even an ARM). So if your budget would comfortably allow $1,500 but the bank is willing to lend you $325,000 for $2,000 a month, you should only be looking to borrow about 75% of that.
People will always complain that homes are too expensive in the Seattle area because it’s a desirable place to live. There was more to that story for a few years when prices really were too high because of all the reasons that have been tossed around on these pages for years, and they probably are still a little too high if you believe this is a “double dip” recession, but even when most reasonable people begin to agree that there is stability in all of the rent/price, income/price, etc… variables there will still be droves of people complaining about prices being too high.
Tim, I reread the Times article, and it seems to say they use a 25% of income for P&I figure, not 30%.
RE: Kary L. Krismer @ 3 – Note my footnote.
The problem I have with the Seattle market is that 20% down on the median home price here is an incredibly high amount of money! It is pretty difficult for your average King County family to put away $80,000 to $100,000. I think the affordability index would be more realistic if it included FHA loans with 3.5% down, since as house prices drop below the $420,000s that is what the majority of buyers here have to get.
I can’t remember if you made a similar affordability curve using c/s index instead of median? I’m not sure if it would look much different but I put almost zero weigth on any metric that uses the median as some sort of home value/price related metric other than the sales mix.
By patient @ 6:
The right number to use would be the average valuation such as measured by Zillow, which uses something similar to CS. But that would imply buying into the underlying assumption of this affordability measure, which is that no one rents apartments or lives in a condo or townhouse. That’s the only way that the median family would correspond to the median house.
RE: patient @ 6 – Good point. When I get home tonight I’ll generate a version of the graph based on the Case-Shiller index translated into to a dollar amount.
By Nathan @ 5:
The thing is though, when you go much higher (a lot higher) than $400,000, the percentage of the downpayment tends to rise dramatically. 20% might be lower than average.
Perhaps we need something like an affordability index at the C-S tier cutoffs, and you’d use 3.5% down at the lower number, and 30% down at the higher number.
By patient @ 6:
Either way you’re using a number that doesn’t apply to anyone, and then making assumptions as to what they’re going to do that applies to maybe 1% of the population, and finally assuming that somehow comparing that to the income of the entire population of the area as if they’re all somehow part of the home purchasing market. Substituting one number that is highly correlated with another will not really solve the problems with this line of thinking.
Buried in the last paragraph of the Times article is this little nugget; “The Washington Center for Real Estate Research also produces a first-time buyer affordability index, using lower assumptions for income, house price and down payment.
In King County, that score for the second quarter was 57.0, an indication housing still isn’t affordable for many prospective newcomers to homeownership.”
Since a large segment of current buyers are first timers, it would seem that housing continues to be too expensive for this segment. Calculating affordability using lower down payments and higher interest rates just kills the rational for the headline splashed the top of the article.
RE: WestSeattleDave @ 11 – That’s exactly what I was referring to. I guess I should have RTFA.
Tim, don’t sweat about the comments section in Seattle Times. It is filled by wackos, nutjobs, and delusional. Until they actually put some admins on that section, it isn’t even worth the electricity to display it.
If you ever needed a proof on the failures of the American education system, you only need to read the Seattle Times comments section.
By gameboy @ 13:
100% agree, if I ever want to feel sad about the state of our society, I just read the comments on a seattle times article.
By hdizzle @ 14:
Haha yep, if you look at other comments on other news articles, it resembles a lot of a gang hating. For some reason, not a lot of people can be positive on an article that’s not absolutely happy.
Great post Tim. Love to read your work as usual even if news paper readers don’t.
Affordability index can be a good “rule of thumb” to guage the direction and strengh of the economy.
All’s I know is my household income is 6 figures, I have no kids, I have 20% down, and I still don’t feel like I can afford a house priced $400K. How people are pulling the FHA trigger with 3.5% down and $70K in household income is beyond me. I mean, what happens if a spouse loses a job or a family member gets ill? Don’t people care about long-term stability in their lives? It appears to me, a lot of people borrow as much as they possibly can at every new moment in time.
IMO, no houses are affordable right now, because buyers like me have to compete with 10 flaky families overstretching themselves to get a dump on a 6K sq. ft. lot. They do this purely out of ignorance and an inability to control their impulsive behavior disorder. Then when they default, I pay taxes to bail their irresponsible arses out. Meanwhile, the govt. floods the market with borrowed dollars in order to artificially inflate the price of the foreclosed home so that the crazy banker who made the outrageously risky loan can continue to live in a house that I cannot afford to buy.
This game is crazy.
Good summary Jonness.
RE: Jonness @ 17 – Here here. I couldn’t have put it better myself except for maybe to add I then have to rent the banker’s guest house and chat with him everyday over the fence about how real estate is the best investment you’ll ever make which i now can’t afford on my six figure salary because of the high taxes I pay as a renter without the homeowner’s tax breaks.
RE: Jonness @ 17 – and what is even crazier, is that only a few see it.
RE: Jonness @ 17 –
Paragraph 1 – Right on
Paragraph 2 – First couple of sentences – Correct; not everyone got the memo.
– Rest of the paragraph – This is what happens when 70% of the economy depends on all of us going to the mall and shop. Remember. “tax breaks” or “rebates” were never meant to be saved; they were meant to get back into the economy by buying platicrap from China. It’s a cycle and breaking it will hurt a lot.
Great post!! You should sticky this in your collection of “must read” articles.
By WestSeattleDave @ 11:
WestSeattleDave — Nice job catching the fine print. That stat hints at underlying shifts in society that thus far seem to be ignored in most discussions of home prices. As a 25 yr old with an interest in becoming a homeowner, let me share my perspective on housing affordability for my generation.
Support for any asset price level relies on back-fill; sellers need a steady stream of buyers willing AND able to assume ownership at a set price level. As buyers become sellers, there exists a need for replacement buyers. From a long term perspective, this becomes an overwhelmingly generational issue (younger people tend to replace older people as buyers, too few young people, collapse of support for home prices). Seems as though this concept would be particularly acute in Housing.
The “willing” part usually isn’t the showstopper, it’s the “able” part that tends to get in the way of a purchase. For this reason the affordability index is an extremely important data point when thinking about home prices.
The score of 57.0 for first-time home-buyers (read: younger people) scratches the surface, by suggesting that many young people flat-out lack the income to handle mortgage payments derived from current price levels, even at depressed interest rates. What it doesn’t address are obstacles standing in the way of the other key components, namely down payment.
The same low income that makes a mortgage payment unaffordable also contributes to difficulty in building a down payment. Additionally, student loan debt and credit card debt compound the problem by creating near term cash requirements that can crowd out savings.
Also worth consideration are shifts in how retirement is funded and changes in the tax base. Company (and Gov’t) assisted retirement is increasingly unlikely, meaning younger individuals have an increasing need to allocate personal funds for their own retirement. Changes in population demographics (read: the average age is increasing) also mean that it’s not entirely inconceivable that my generation’s tax burden will increase in order to fund previously committed government obligations like Soc. Security and Medicare, which will also negatively impact the amount of income available for housing.
Finally, it seems to go unmentioned the wealth loss some in the 20-30 age group has experienced as a result of the housing crash. It isn’t a crazy assumption to guess that on balance many in the 20-30 age group who currently “own” their house purchased during the boom years. Loss in home values have likely wiped out what equity they had in their homes (including the savings they put down on the purchase).
These issues can more readily be overcome in a high affordability market, but I don’t think Seattle falls into that category.
These factors are influenced by a lot of uncertainty, so it’s difficult to weigh which ones are material and which are just noise. Since they rarely are brought up in the discussion, maybe they are all just noise. On the flip side, maybe the factors really are important and have been overlooked because the 20-30 age group’s lack statistical representation.
However, if it happens to be the latter I think we can expect more trouble in the Seattle real estate market. Take a look at this chart http://www.censusscope.org/us/m7600/chart_age.html of age distribution in the Puget Sound metro area, then compare it with this chart http://www.censusscope.org/us/m7160/chart_age.html of the Salt Lake City metro. See the difference in backfill?
Between affordability and back-fill, I think you’ve got two really crucial statistics needed to predict (guess) home prices, and neither seems in Seattle’s favor.