Appendix: Inflation and Housing Affordability

Nominal measures of housing affordability like those used in this paper reflect 'actual' affordability by highlighting the difficulties of meeting the terms and conditions of a mortgage contract for those who need to borrow to purchase a house. However, some of these difficulties are not caused by the purchase price of the house nor the real interest rate, but by inflation. As such, it is also useful to examine housing affordability in real terms by removing the effect of inflation and measuring 'underlying' affordability.[18]

Inflation results in 'front-loading' of mortgage repayments since it leads to larger real principal repayments during the early stages of home ownership. Home loans in New Zealand are typically table mortgages, which require a series of monthly payments determined by the loan's maturity term and the nominal interest rate. For instance, if inflation is 2% per year, the real value of repayments on a 25 year loan of $100,000 with a 7% interest rate declines from about $8,400 at the end of the first year to $5,200 at the end of the 25^th year. In contrast, if the inflation rate was zero, there would be a constant repayment of about $7,100 a year over the life of the mortgage (Figure 16).

Figure 16 - Real repayment stream of a 7% 25 year $100,000 mortgage (inflation = 2%)

Source: Coleman (2008) modified

Another way to view this is when nominal interest rates rise due to inflation, monthly mortgage payments also rise, but the increase reflects more rapid real principal repayment rather than a higher real cost of housing. For example, if someone takes out a $100,000 loan at an interest rate of 7% per year when inflation is 2%, the $7,000 interest payment comprises $5,000 real interest payments and $2,000 to compensate the lender for the erosion of the initial value of the capital due to inflation. This $2,000 is effectively saving by the borrower because it reduces the real value of the remaining debt to $98,000. So while nominal affordability indices provide useful information about the financing difficulties facing credit-constrained households, they overstate the average lifetime cost of the mortgage as they do not take into account the expected decline in the real value of the payment stream over the life of the mortgage. An index based on the real mortgage rate makes this adjustment.

Housing affordability measured in nominal terms is considerably worse than real affordability, and the gap increases with the inflation rate. The number of hours of work, paid at the average hourly rate, required to service the nominal interest payments on a median priced house is much higher than the number of hours work required to service the real interest cost (Figure 17). The nominal and real indices follow a similar trend, with both deteriorating during the recent house price boom, but improving more recently.[19] However, part of the deterioration in nominal housing affordability during the house price boom was due to high inflation rates. In fact, while nominal affordability was at its worst during this period, real affordability was better than in the mid-1990s.

Figure 17 - Real and nominal affordability indices

Source: Coleman (2008) modified

While real affordability indices remove inflation and therefore better reflect the lifetime cost of a mortgage, this is no consolation for a would-be homeowner who faces high debt repayments, particularly during the early stages of homeownership. Higher inflation rates make it more difficult for households to meet the terms and conditions of a mortgage. This highlights that with standard mortgage contracts, even moderate levels of inflation can negatively impact on the ability of credit-constrained households to meet home loan borrowing costs.