Economist's Commentary: June 19, 2008

Making Sense of "Affordability"

By Ken Fears
Manager, Regional Economics

Affordability is one of the key determinants of home sales. But the term affordability is often used without a fundamental understanding of its meaning. Intuitively, one would expect affordability to be a representation of whether home prices are in line with incomes, but there is more to it than that. Creating an adequate measure of affordability is difficult, and there are problems creating a definition that is meaningful across all markets.

NAR's affordability index is simply the ratio of 25 percent of the median family income divided by the monthly payment on the median priced home, assuming a 20 percent down payment and the current interest rate. An index reading greater than one suggests that a family with the median income would have more than enough income to afford a home priced at the median. Thus, an increase in this index points to rising affordability and a decline in the index suggests falling affordability.

One major flaw with this affordability measure is that it assumes that all people should devote 25 percent of their income to paying housing costs. While this may be true for the family buying within a median priced market, it might not make sense in a higher priced market. The pool of home-buying households in higher-priced markets tends to have higher incomes because of employment opportunities in these markets or market characteristics that draw higher-income persons to these areas (e.g. weather, beaches or entertainment). However, the average amount of goods that people purchase each year is not directly proportionate to their income.

According to the 2006 Survey of Consumer Finances, as a percentage of income, expenditures fall sharply from 92% in the third income quintile to 63% in the highest income quintile. This finding suggests that people at higher income levels have more funds left-over after the basic expenditures are covered.

Similarly, as a percentage of income, expenditures on housing fall sharply as income rises. This trend is the average for the nation as a whole, but may not speak to the pattern of those high income buyers, who choose to buy in more expensive markets.

This last point helps to explain the apparent lack of affordability in many of the high priced markets that still experience strong home sales and resilient prices. Since people in the higher priced markets tend to have higher incomes, they can devote a larger than average portion of their income to financing a home purchase. Hence, the ratio of debt payments relative to income, a measure derived from the affordability index, might suggest a substantial difference in debt burden in a market like Syracuse, New York compared to New York City. This relationship, though, does not necessarily imply that there is an affordability issue in either market unless one assumes that this ratio should always be less than the national average of 25%.

These findings suggest that not all cities should be compared with the national average for expenditures as a percentage of income. Residents in certain areas, particularly more high-cost areas, tend to have higher incomes which influence their spending patterns. A better understanding of the differences in budgeting between low and high income households is telling, and may shed light on why a decline in interest rates can spur a surge in home sales in high-cost markets despite a perceived affordability problem as defined by the current measure. The current affordability measure is simple and provides valuable insights into affordability, but its effectiveness could be improved.

This is one in a series of commentaries by the Research staff of the National Association of REALTORS®. Read more commentaries >

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