Home prices are decided by what buyers can afford. Here’s how to calculate affordability.
As an investor, you have to understand where prices are now and where they’ll be in a few months.
If you buy a property now, then 4 to 6 months from now is when you’ll either be selling as a flip or appraising for refinance.
For medium-priced homes and below, purchases are mainly based on affordability. Interest rates dictate affordability. Affordability dictates the value of homes.
So let’s look at the numbers. We’ll use an example of a homebuyer who can afford a $1,000 monthly payment right now at the end of 2022.
How to Calculate Affordability – The Payment
Affordability is the monthly payment a buyer can afford. This number is determined by:
- The buyer’s financial comfort.
- The income and budget of the buyer.
- And most importantly: the lender’s qualification requirements.
Many buyers would feel comfortable paying a higher monthly amount, but they’re restricted by their lender. Affordability is a major factor in the loan approval process. Buyers in the mid- to low-price range only get approved for one monthly number, regardless of market conditions or property values.
How Affordability Changes Buying Power – The Price
Interest rates are currently at a 7% average. Only being able to afford a $1,000 payment, this buyer could qualify for a $150,000 home. The $150k is their “purchasing power.”
But interest rates are expected to increase to 8% next year. What happens for this buyer then?
When interest rates rise, purchasing power falls. This buyer still only qualifies for a $1,000 payment, but at an 8% rate, they can only afford a $136,000 house.
What if rates rise to a whopping 9%? Buying power for this buyer decreases to $124,000.
A $124,000 house with a $1,000 payment may not be realistic in many markets today. You have to see what the current environment is in your area, and base your numbers on current interest rates and property values.
How Affordability Impacts the Seller
Affordability doesn’t just impact the buyer; it should also change your expectations as a real estate investor. With higher interest rates, affordability will drop. You have to take this into account when you’re buying properties in this market.
If you buy a house right now in the 7% market, you expect it to sell for $150k. However, you need to keep changing interest rates and affordability in mind. In 6 months when you’re ready to sell, interest rates may be at 8% and your list price will sink to $124k.
Each time interest rates rise by 1%, prices drop by a little over 9%. When interest rates go up 2%, there’s a 17.3% drop in values.
Rates when you’re buying matter less to price than rates when you go to sell. You need to anticipate where rates will go. If rates rise 1-2%, you have to account for affordability.
This balancing of affordability and buying power is one of the biggest factors in home pricing. The majority of people buy based on payments and affordability. Their payments are not going to change despite price changes.
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