Money Management and the Economy

Sunday, August 10, 2008

Don't Buy a House Now

You aren't smarter than the market. It really is that simple.

There have been several articles lately that I suspect are part of a determined effort by the real estate industry to get people back into the housing market. The basic pitch is that higher interest rates will eat up any savings you get from waiting for lower prices. Even the New York Times has gotten in on this action.

The calculation always goes something like this. Say you have a house for 500,000 and you make a $100,000 down payment today with a $400,000 mortage at 6.5%. Now compare that to a year from now if housing prices fall by 10%, you would make a down payment of $90,000 and borrow only $360,000, but at a higher interest rate. If the interest rate is high enough, you will end up with higher payments and paying more total for the house than if you purchased it now.

There are two problems with that calculation. The first is that isn't really how people buy houses. People decide how much they can afford and then find the best house in their price range. So the actual comparison is if I can afford the payments on the $500,000 home today, what will I be able to get for that money a year from now. If you assume prices will fall 10%, then a house selling for $555,555 today will sell for $500,000 a year from now. Of course, whether you can afford it will depend on the interest rate - that was the point of the above exercise.

So what can you afford to borrow at different interest rates?
Your monthly payment at 6.5% on $400,000 loan is $2528:
at 7% you can borrow $380,000
at 7.5% you can borrow $361,000
at 7.8% you can borrow $350,000
at 7.97% you can borrow $345,000

So if you assume that you can get a 5% return on your $100,000 down payment, you will still be able to afford that house priced at $500,000 if it drops to $450,000 a year from now and interest rates don't go beyond 7.97%.

This brings us to the second problem with the calculation. Interest rates help determine the price of houses. If interest rates approach 8% a year from now, then housing prices are very likely going to drop a lot more than 10%. In fact, if you look at the example above as the typical buyer for a $500,000 home today, an increase to 8% interest, by itself, will force the price of that house down by more than 10%.

At this point, interest rates have not even been a significant factor in the plunge in housing prices. The housing bubble pushed prices well beyond their fundamental value when compared to the cost of renting and family income. And housing remains overpriced by those measures in most markets. If interest rates go up, that will only add to the market correction.

Finally, going back to the example above. If you plan to buy a house to live in for a few years, then the current fluctuations in price won't matter very much. But if you can wait a year and buy a house that is worth 10% more than the house you can buy today, you will be way ahead. Not only will you get more for it when you sell it, but you will have had the benefit of living in a nicer house for as long as you owned it.

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