Monday, September 28, 2009

Buying a home - revisited

We received a great comment on the recent post dealing with mortgage rates from someone named OptimizedPrime on Seeking Alpha. Here is the full re-print of the comment and some responses:

Yep, great time to buy. You know what happens when interest rates inevitably go back up? Your newly purchased house's value drops like a rock!

Put that in your spreadsheet and smoke it.

Here in the US house prices are virtually indexed on interest rates (people pay the PAYMENT not the purchase price), so the minute they go up you can expect price drops FAR BEYOND THE CURRENT MARKET CORRECTION.

So let's take an example, shall we?

A working couple buys a house for $330k with 10% down at 5% interest. Their payments are $1600/month give or take.

With that, you can surmise that the price of their house is not "$330k", but actually "$1600/month +30k down".

Now imagine interest rates pop up to a more sustainable 10%. This is not AT ALL out of the question when the government stops forcing taxpayers to keep your mortgage low by subsidizing the market (if there's any hint of inflation on the horizon, then 20% is more like it but let's just use 10% to make it easy).

But let's just see what rates going to 10% does here.

Now the same 1600 will get you a loan for $185k. Add your 30k down and you can afford a house for $215k.

In other words, the change in interest rates have made the EFFECTIVE "price" of your house DROP from $330k to $215k. This is a 34% drop in price, or a loss of $115k, which is to say about 3x your down payment. (You are way underwater now btw).

In this scenario you are much, much better off renting and paying the higher interest rates when purchase prices come down because:

1. You'll pay less property taxes (esp. in prop-13 limited CA).

2. You down payment will be a much bigger percentage of the purchase price meaning you will purchasing less of other people's money.

3. You will actually have equity in the house vs. being deep underwater.

4. When interest rates come BACK down, you can refi and get the best of both worlds.

Is this all to say that the latter scenario is "better" somehow? Inflation certainly muddles the picture, but assuming your down payment is carefully invested you will be much better off putting it in some other asset (even WITH the leverage).

What this really means is that interest rates are essentially a "wash". There's nothing inherently good or bad about interest rates being low. Low interest rates in many scenarios can be much, much worse than high interest rates.

You should therefore not take interest rates into consideration when you decided whether to or not to buy a house. Low interest rates (like these) that have no direction to go but UP are for suckers.


OP makes some excellent points. In some areas real estate definitely moves (or at least used to move) with mortgage rates. As mortgage rates go higher, "affordability" drops and so does the price. However that tends to be driven by "stretch" buyers. When real estate is overpriced beyond most people's means, every basis point in rates makes a difference in whether a stretched buyer can afford it (particularly in California). That's not so much the case these days, particularly outside the overpriced areas.

Here are some common sense thoughts on buying a home:
1. Make sure you can comfortably afford the mortgage, and would have been able to afford it even if the rates were higher. Check those taxes.
2. Make sure the house has utility value to you. That means you really want to live there for many years and are not buying purely as an investment. If you are buying a house to flip it, you are asking for trouble.
3. Make sure the house does not require significant additional initial investment.

Assuming you stick with the guidelines above (and there are plenty of better qualified professionals out there who can give useful guidelines), here is why buying a home should be just fine.

1. High rates probably means we've got inflation. At least that was the situation in the 70s. Financial assets don't do well during high inflation - just look at some charts form the 70s of stocks and bonds. Commodities do well, but most people need a home, and you can't live in your gold bars. Your house price should at least be stable.

2. With a weaker dollar, foreigners are going to like your home. Have you seen the crap you get for your sterling around London lately? That's why the Brits love those homes in NJ.

3. If you currently already own a home and need a bigger one because your family needs a bigger home, you don't have much choice. If the new house works for your family now, in years to come this house will work for someone else's family. Remember, the US population gains one person every 10 seconds. With new construction significantly down, the demographics will take care of the rest:

From VOX, William C. Wheaton:
During the last decade, net new household formation averaged approximately 1.4 million per year. Last year, the Census reported that the US added only 544,000 new households – during severe contractions the young stay at home, singles “double up”, and household formation (normally) slows. Even with declining demographics, however, most analysts foresee new household growth resuming to a level of at least 1 million by 2010 and beyond. If we conservatively add 200,000 demolitions per year, the US economy will “need” at least 1.25 million new units yearly in the near future. With today’s currently depressed construction, this generates a yearly deficit of 750,000 units.

4. If you rent, just remember that OP's logic above applies to rents far more than it does to home prices. Rates go up, so do rents. That's because as rental properties become more expensive to finance, they need to charge more to make any profit. If you are in a rent-control place, it's a different story. If not, you run the risk to have your rent raised to painful levels. At least with a 30-year mortgage, your housing expenses are fairly stable.

5. Even with the financial hell we've been through, mortgage lending is a great business for banks. Decent credit, proper paperwork, 30-year fixed mortgage, and a 30% downpayment, all make for a quality loan. Remember that you probably are a better credit than that restaurant around the corner or the strip mall down the road, and banks know it. Mortgage lending isn't going anywhere and neither is the tax deduction.

Keep in mind, the US government, particularly the Fed is trying to re-inflate home prices. It's not clear how successful they will be, but if you just want price stability and you buy a home now, over a period of time you should be fine. Mortgage rates are definitely going up, but that doesn't mean home prices are going significantly down in the long run.

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