Two Factors In Buying a House

Discussion in 'Economics' started by OldTrader, May 25, 2005.

  1. Recently a guy asked me whether I thought he should buy a house. In the process of attempting to provide him with an answer, what occurred to me was that there is more than simply price that is important in terms of the purchase of a house. Interest rates are easily as important if not more important IF you will be financing the house...which is true for most of us.

    What seems to be talked about here ad infinitum is the idea that 1) there is a bubble and 2) once the bubble bursts prices will go down.

    Let's assume that's true for a moment. Let's assume that a guy buys a house today for $200,000 and finances it all at 5.5% for 30 years. The downpayment will be unimportant at this point for our analysis. The principal and interest payment on the above terms is $1135.58 per month. Taxes and insurance will be consistent within the examples I use. Now fast forward to exactly 10 years from today. You have made each payment on a timely basis, and therefore your loan balance at this time is $165,081.

    The next example we shrewdly realize there is a bubble, that prices are about to fall. We turn out to be correct. Prices decline 10% over the next two years, so that 2 years from now we finance the house for $180,000. The rates in the interim rose (it was part of the reason prices declined). And therefore the interest rate on 30 year mortgages is now 8%. Thus the prinicipal and interest payment would be $1320.78. Yikes! The payment is nearly $200 more, eventhough we are financing less. Again, downpayment, taxes, and insurance are all the same. Now fast forward to 8 years from other words, we are going to compare where we stand in 8 years with where we would have stood had we bought the house 2 years earlier at a higher price. Looking at the amortization schedule, the loan balance is $163,831.

    In other words, in example one we buy the house, which then immediately declines 10%. In example two, we buy the house 2 years from now after the decline of 10% has taken place, but at a higher interest rate of 8%, the reason prices declined. Yet the loan balance is nearly the same, and in example one we save nearly $200 over example two on a month basis. In excess of $2K per year. In the 8 years that each example holds the house example one saves $16K over example two, even though he paid $20K more for the house.

    You tell me which buyer got the better deal. The first buyer paid too much, but got the better interest rate. Buyer two got the better price, but paid more in payment, and will pay more for the life of the loan. Loan balances are very similar at the 10 year period.

    Now, understand this is just one scenario. But understand that there are two components in the home is the price of the house, the other is the interest rate. And the interest rate can easily overcome some disadvantage in price if the rate is much different.

    The point is, put the pencil to some of the scenarios. You may be surprised, especially if you plan to hold the property for let's say a 10 year period.

  2. I assume this example would not be valid for those

    stretched out with ARM's over a few properties ?

  3. If you change the terms of the loan then you change the example. If you want to figure out what would happen with an ARM, you just pencil the situation assuming the worst case scenario of the ARM. Some ARM's have a fixed rate for a specified period, and then the rate "may" escalate depending on the index it is tied to, but possibly with a maximum adjustment each year. Other ARMs start lower, but have no fixed rate period, and adjust each year according to their index, with a maximum ceiling per year. Again, without knowing the terms you cannot figure out what the impact is under a scenario. That's one of the problems here on this board...alot of statements are made with precious few facts.

    In terms of multiple properties, nothing changes in and of itself whether we are talking one property or multiple properties. But one additional factor is how the proposed payment on multiple properties is to be covered. In my case I don't ever buy a property unless it pays for itself from day one. But again, I pencil all this out in advance.

  4. If housing prices decline by only 10% while mortgage rates rise 250bp, that's not a bubble bursting. That's a rational market.

    A correction of 30% or more would suggest that there was a speculative bubble.

  5. You should also consider the additional rent you will need to pay over the two years that you wait to purchase the house at a 10% decline. If you are not renting but currently own a house, you should factor the 10% decline in the value of your own residence.
  6. kubilai


    Don't forget to add the money you saved from renting for two years. In most hot housing markets these days you save a bundle by renting instead of owning the same caliber house.

    You do have a very good point though, made me look up the the average mortgage rates in the last decade. The 30 yr ranged between 5.5% and 8.5%. oldtrader isn't just throwing random numbers about.
  7. I think it's important to point out that there has never been a decline of any magnitude over the last 50 years in the median house price nationwide. No declines at all. Only advances. I've posted a link to this several times. There have been declines on a more localized basis. California, Texas, etc. But not nationwide. Declines in the past have taken place in combination with job problems. Texas for example when the oil prices collapsed and the oil industry downsized after it happened. California coincided with based closings and job loss.

    So IF you're forecasting a decline of 30% NATIONWIDE it not only has never happened, it is of a magnitude to make it a pretty off the wall type of forecast. Could it happen? Of course, anything is possible.

    And IF a 30% decline happened you would be better off to have waited by any calculation. The question is how you fare if it doesn't? Clearly if prices only decline by 10% there is no advantage, in fact there is some disadvantage, to wait. And certainly if prices simply flatten out you are at a big disadvantage.

    I think the point here is to pencil out some of the scenarios so that you can see how you fare, and then to establish some set of probabilities as to what you believe will happen.

    By the way, a 30% decline simply takes California real estate back to where it was at the start of 2004. Many here have been calling for a decline much longer than that. Don't know how long you have been.

  8. What if interest rates go down? I think that is one of the factors driving this market. Interest rates are going to be much lower in years to come which will keep purchases attractive, IMO.
  9. This is the other prediction folks have been making for the last several years...that rates would rise. Hasn't happened yet has it? But the homeowner can continually refinance if this is the case, thereby lowering his payment.

  10. kubilai


    I've been thinking that the best analysis to do to make the buy now vs rent and wait decision is to simply compare the cost of owning vs renting. In the San Fran bay area this is at around 2:1 ratio right now, so by renting and waiting I can save a bundle which can be dropped directly into the down payment when the ratio comes down toward 1:1.

    If houses depreciate but interest rates go up that ratio will stay high, so I still won't buy. The worst scenario is if houses don't depreciate, interest rates stay up, and rents shoot up bringing the ratio to 1:1 anyway. Well that'll be my give-up-California-dream-move-somewhere-reasonable signal.

    Are there any holes in my reasoning?
    #10     May 26, 2005