Rising house prices in some of Australia’s hottest property markets might seem scary to many people, but houses are relatively more affordable today than they were in 1990, argues Jamie Alcock, associate professor of finance at the University of Sydney Business School. In an opinion piece published on the Domain Group website, Alcock said it was actually the growing interest-rate risk that was the biggest problem facing first-home buyers.

“If you look at [the] latest numbers on house prices, as a measure of affordability, they use a ‘median measure’ – that is, the ratio of median house price to median salary,” he said. Currently, the price of a median house in Sydney is 12.2 times the median salary; this figure falls to 9.5 times the median salary in Melbourne, according to the latest data from Demographia

“But it’s simply misleading to compare median-based measures of housing across different time periods in the same location. These simple median measures do not take into account differences in interest rates in different time periods,” Alcock said.

A typical house in 2017 costs nine times the median salary, when mortgage interest rates are less than 4%. This is arguably more affordable than a typical house in 1990, when homes cost six times the median salary (according to loansense.com.au, interest rates in 1990 were 17%). 

Consider the following example: In 1990, a first-home buyer purchases a home in Sydney priced at $194,000. “With mortgage interest rates at 17 per cent, the monthly mortgage repayments were $2,765 for a 30-year mortgage. But in 1990 the average full-time total earnings was only $30,000 per annum, so the buyer’s mortgage repayments represented over 111 per cent of before-tax earnings,” said Alcock.

In contrast, a first-home buyer purchasing a home in Sydney for $1m, with interest rates at 4%, is only required to pay $4,774 each month, or 69% of their before-tax average full-time total earnings.

“Relatively, houses are substantially more affordable today than they were in 1990. The lower interest rate means the costs of servicing a mortgage is lower today than it was 25 years ago, or even 50 years ago,” said Alcock.

It’s the very real interest-rate risk that is making the situation less stable for the current generation of homebuyers. According to Alcock, interest-rate risk is the potential impact that a small rise in mortgage interest rates could have on the standard of living of homeowners. This is assessed by examining how a 1% change in interest rates would affect the repayments required on a variable-rate mortgage.

Interest-rate rises are of course tied to mortgage repayments. But the proportional increase in repayments is greater when interest rates are lower. “For example, if mortgage interest rates were 1 per cent, then increasing interest rates by another 1 per cent will double the interest costs to the borrower. When interest rates are higher, a 1 per cent increase in interest rates will have a lower proportional [effect] on their repayments,” said Alcock.

Returning to the first example, the interest-rate risk of the first-home buyer from 1990 is much lower than the first-home buyer from 2017. “If mortgage interest rates rose by 1 per cent in 1990, repayments would rise by only 5.7 per cent to $2,923. For the 2017 buyer, on the other hand, a 1 per cent increase in interest rates would see their repayments rise by over 12 per cent to $5,368 per month.” 

This large increase in repayments could financially derail first-home buyers. “Interest rate risk has an inverse relationship to interest rates – when interest rates fall, interest rate risk rises. As a result, interest rate risk has been steadily increasing as mortgage interest rates have fallen,” said Alcock.

Given the current historically low interest rate set by the RBA, the corresponding interest-rate risk has never been higher.