I advice consumers to buy a property that is within 5 years of the annual income, repay the loan within 25 years and have the repayment at not more than 25% of the annual income.
How do these figures tie up together?
The following table shows that you can only pay the purchase price should only be 3.91 years of income, if you wish to repay the loan over 25 years at an interest rate of 4% and a monthly repayment of 25% of income.
I used an interest rate of 4% as the long term rate of interest, i.e. 2% above the rate of inflation, which is assumed to be 2% over the long term. The current interest rate may be only 2.6%, but this is at a historically low level. Interest rate is likely to increase in the future. To be prudent, you use an interest rate that reflects the likely long term trend.
If inflation is assumed to be at 2% per annum, you can assume that your earnings will also grow at the rate of inflation. This means that you can afford a mortgage repayment to increase by 2% per year. The effect of this increasing payment can be calculated by reducing the interest rate by 2%, i.e. to use 2% instead of 4%. The table shows that you can afford a property that is 4.88 times of your annual income, i.e. close to the benchmark of 5 years that I have recommended.
Some people think that they can stretch the loan repayment period to 30 or 35 years, as they are likely to be working for longer than 25 years. It is more prudent to use a 25 year repayment period, to allow for the possibility that the working life may be disrupted for a few years due to unemployment, disability, continuing education or an extended vacation break. This will give a margin of 5 to 10 years that is free of the mortgage repayment.
As the family income, usually of two working persons, is used for the computation, it is important to use a 25 year repayment period, rather than a longer repayment period, as there is a higher risk that one or both of the income may be disrupted in the future.
Are property prices too high or low?
Here is a way to judge if the current market price for a property is at an acceptable level. If you find that that, on average, a person buy a property that is more than 5 years of the family income, If prices are too high, you should consider the option of renting a property until the price corrects downwards.
Tan Kin Lian
26 March 2011