Low interest rates are a form of economic junk food.
It's true in the housing market, where low rates have glossed over a striking decline in affordability in the past two decades. A sustainably strong housing market is based on fundamentals like a reasonable match between growth in incomes and home prices, not the economic equivalent of fat and salt.
Most of us have at least a basic idea of how much house prices have gone up in recent years, but there's been a lack of curiosity about how buyers are keeping up. For some perspective, let's look at incomes as taken from Statistics Canada data on weekly earnings going back to 1997, and real estate price data supplied by the Canadian Real Estate Association.
Back in 1997, the average house price in Canada of $154,620 was about 4.9 times the average pretax annual income ($31,484) of an individual with a full-time job. For the year through July 31, the average price of $379,725 puts houses at about 7.8 times income. ($48,497, all figures in current dollars).
A reasonable long-term assumption is that houses will rise in price by the inflation rate every year on average, and that wages will more or less keep up with inflation. That would give us a kind of affordability equilibrium in the housing market.
But house prices have surged ahead of income. In the past 17 years, incomes have risen by an average annual rate of 2.6 per cent, while house prices have gone up 5.4 per cent. Put another way, house prices have more than doubled over that period, while incomes are up by just a bit more than half.
The surge in housing prices is the great gift of the global financial crisis five years ago. The crisis drove interest rates down to historic lows, thereby allowing buyers to shrug off a growing disparity between their incomes and the cost of buying a house. The availability of 30-, 35- and even 40-year mortgages a few years back also helped obscure the income-house price gap.
But rates have been the big stimulus for the housing market. The prime lending rate at banks and credit unions – it's used to price variable-rate mortgages – fell as low as 2.25 per cent from 6.25 per cent in mid-2007 before edging back up to the current level of 3 per cent. The average posted rate for five-year fixed-rate mortgages fell to 5.14 per cent at mid-year from 7.24 per cent in 2007.
You can chop roughly 1.5 percentage points off those five-year fixed rates to get the discounted costs that borrowers typically pay. On a $400,000 mortgage, the decline in these discounted rates over the past five years would have saved a buyer about $470 per month.
That's what kept houses affordable while prices left income growth behind. Can we keep living this way? A lot depends on interest rates. The Organization For Economic Co-operation and Development said last week that Canada may need to start pushing up rates next year, and that our central bank's benchmark rate may need to more than double by the end of 2015.
But that almost certainly won't happen. BMO Nesbitt Burns has interpreted the Bank of Canada's latest words on rates to suggest that the status quo will rule for at least another year. So we're good on housing, right?
Low rates were needed to stabilize the economy back in the financial crisis, and they may still be required. But let's recognize that they're having an unhealthy effect on housing by getting people into homes that are going to be tough to manage financially.
At some point in the next couple of years, the economy is going to surprise us on the positive side. Anyone who buys a house now or bought in the past two years or less has virtually no chance of avoiding a sizable rate increase at renewal, and that means a higher cost of living.
A more enduring foundation for affordable housing is a match between incomes and house prices. It's sometimes said that a house should ideally cost three times your annual salary. That's laughably out of date, so let's say three times your household income.
With two average wage earners in a household, the ratio of price to income falls to 3.9 from 7.8. If that seems okay to you, consider that house prices in October rose 8 per cent over the same month a year earlier on a national basis. Anyone get an 8 per cent raise lately?
Follow Rob Carrick on Twitter: @rcarrick