Housing affordability is a prime element of the housing cycle, but often in a perverse way. At the height of the buying frenzy of the mid-2000s, affordability had deteriorated significantly. In fact, unaffordable conditions triggered the pull back in demand that began in 2006. Currently, measures of affordability have settled down again to sustainable levels. As a result, demand is beginning to respond.

Affordability can be measured for an individual or generically for a place or across time. For most buyers and certainly for lenders, the largest drivers behind affordability are interest rates and house prices. Except for the 20 percent of home buyers who pay cash, a mortgage is needed to buy a home, and mortgage payments are dictated by underlying mortgage rates—which an individual buyer has little control over—and the house price. Hence, buyers with a set amount of cash for a down payment have a relatively narrow price range since all the other parameters are set by the market. But, at different points in time, interest rates and house prices do change and then affordability changes. These changes can be tracked in at least three ways.

The payment-to-income ratio that is dictated by mortgage underwriting standards sets a limit to the proportion of income that can be dedicated to housing. An individual can afford more house if interest rates or house prices fall. At the height of the housing boom, 30-year fixed-rate mortgage interest rates were roughly one percentage point higher than they are now. And house prices were 10 percent to 30 percent higher, depending upon the price index and location. The combination of price and interest rate declines mean that a monthly mortgage payment on a typical new home has fallen about 30 percent from peaks in early 2006. The fall in mortgage payments has increased affordability significantly even if incomes have not changed significantly. And waiting longer for even lower house prices may not serve a buyer well.

At current interest rates, a one-quarter percentage point change in mortgage interest rates has about the same impact on affordability for the median-priced new home as a $6,000 change in mortgage amount. As interest rates creep up, home buyers who wait thinking that house prices will fall further must see at least another 3 percent or 4 percent decline in prices to maintain the same level of affordability.

A market’s affordability is measured by comparing income levels to house prices. From 1991 to 2001, the national price-to-income ratio averaged 3.2, but by the mid-2000s the ratio climbed to 4.7—houses sold for almost five times national income levels. Significant price declines and lower mortgage rates have pushed that ratio back to 3.1. In some areas, the ratio has fallen below the long-run average, suggesting that house prices have over-corrected in those places.

The NAHB-Wells Fargo Housing Opportunity Index (HOI) is a more sophisticated measure of regional or across-time housing affordability. The HOI measures the share of recently sold homes that the household with median income can afford. Since the HOI is based on monthly payments, the HOI picks up variations caused by interest rate changes as well as relative differences in incomes, house prices, and property taxes across markets. The national index averaged 60 between 1992 and 2002 before dropping to a cyclic low of 40.4 in the third quarter of 2006 reflecting the rapid rise in house prices relative to incomes.

Since the beginning of 2009, the index has risen to over 70 as both house prices and interest rates have fallen significantly. The current record high HOI is further confirmation that affordability is at its best in recent history. The most improved areas are in the states that experienced rapid house price increases. Of the top 50 metro areas with the greatest improvement in affordability three-quarters of them are in the four headliner states of Arizona, California, Florida, and Nevada.

By any measure, affordability has improved significantly since the mid-2000s boom and may be at a peak as interest rates drift up and house prices reach a bottom.

Learn more about markets featured in this article: Phoenix, AZ.