I have heard many people say that inflation in our housing market will lead to higher interest rates which will ultimately lead to an affordability crisis and a significant drop in housing prices. I have not seen anything to quantify this so I decided to do just this; determine for a given interest rate, what the purchase price has to be so that the payment is unchanged. It really is a straight forward exercise, vary the purchase price for a given interest rate, such that the principal plus interest payment for a loan is the same. The purpose of this post is to understand the following:
- What changes to the purchase price for each annual rate will need to be to get the same principal plus interest payment.
- The impact on the loan term (15 year versus 30 year) and how it impacts the purchase price for the same principal plus interest payment.
- The impact on purchase price as the government raises treasury rates to combat inflation.
1: If interest rates decrease to 4% for a house, worth $200,000 when prevailing rates are at 5.00% for 30 years, that person can pay $224,885 for the same property (an increase of 12.4%) without an increase in the principal plus interest. Alternatively, if interest rates rise by 1% to 6%, that same house would sell for $179,074 (a decrease of 10.5%) without an increase in the principal plus interest payment.
2: If a person chooses to use a shorter rate term (15 years instead of 30 years), the impact on affordability is reduced because the total number of payments are reduced. For this reason, when the population of people generally use a 30 year loan, that defines the worst case scenario for housing affordability. For situations where loan terms decrease in duration, the impact on changes in housing prices (higher and lower) is muted.
3: If inflation is tracking at something like 6% year over year and if we believe that housing will keep up at the prevailing inflation rate (new builds are affected by labor, energy, and materials), a 1% increase from 5.00% to 6.00% will only go down in relative value by something like 4.5% (-10.5% - 6%). If inflation tracks at 6% for two years, housing should be above our current rate in two years. For this reason, long term inflation will significantly increase property prices faster than the temporary drop due to affordability. This does assume that wage growth tracks with the inflation rate which may or may not happen.