This is just a quick diary based on an exchange I had in the comments section of a front page post earlier today. I thought I would debunk some media/NAR spin about buying real estate now, while rates are low! I think this diary fits into the DKos purpose, because becoming educated about this will help people's political judgment, and perhaps their personal finance.
Buying a home or condo while interest rates are low is the worst time to buy (all other things being equal). If interest rates have nowhere to go but up, then home values have nowhere to go but down. This is the exact opposite of what you learn in school and contrary to propaganda put forth by lots of people, including the government.
Read below to see why.
Buying a house is a business decision. You borrow a certain amount of money from a bank at a negotiated interest rate that more or less matches the prevailing interest rates. If you are deemed to be a good credit risk, you'll get a slightly better rate and terms, if you're a bad risk you'll get a worse rate or will be simply denied the loan. Interest rates are negotiated on a market: on one side are borrowers who want a low rate, and on the other side are lenders who want to maximize their rates. Looming over all of this are the rates on T-bills: as a bank you'd never invest in a mortgage at 5% if you can just buy a 10-year T-bill at 5% and save yourself the aggravation.
The price of housing is payment-driven for the most part. Buyers usually do not look at the absolute value of the loan they are taking out: it's all about the payment. Consider: I offer you a house that costs a million dollars, but your payment will be $20/month. Anyone would take that deal, right?
So, let's consider a house that costs $200k. If your interest rate is 5%, an interest-only mortgage would cost $10k/year on that house. Rational lending guidelines say that your home payment should be under 33% of your gross salary, so someone who makes $30k could (barely) afford the mortgage on such a home. [We're going to deal with interest-only mortgages here to make the math easier: the same principle can be easily extended to 30-year amortizing mortgages. In reality, of course, someone who makes $30k could in no way afford a $200k house].
Now, let's raise interest rates to 10%. With the home still at $200k, the $30k earner cannot possibly be approved for the $20k yearly payment that this house would cost: there is no way since it is 66% of his/her income.
However, all housing stock still exists as it did with interest rates at 5%. The most expensive house in the town can only be afforded by the richest person in town, who can outbid everyone else. The second most expensive house can only be afforded by the second richest person, etc. This effect percolates down the entire economy until we get to the $30k earner. Suddenly, the owner of the $200k house has no one to sell to, because the $30k earner cannot afford the house at 10%, and people who make more money are still buying the more expensive houses.
Since no one who would want to buy the $200k house can buy it, the price must and does fall to compensate. How far? Well, in our example, at 10% interest on an interest-only loan, the $30k earner can only ever spend $10k/year on a home. So, he can only buy a $100k house since he will only ever be approved for a $100k home at 10%!
The result of this is that due to the rising interest rates, the price of the home has fallen... from $200k to $100k! The previous owner is now underwater by $100k and is stuck paying $10k on his $100k house!
However, if you had bought the house at 10% interest, the price would have only been $100k with the same payment: $10k! And now, when rates fall to 5%, we're only paying $5k/year for the same house that the other guy is paying $10k/year for... and is $100k underwater.
Net result:
The guy who bought at a 5% interest rate is now $100k underwater and is paying $10k a year into his house when rates get to 10%.
The guy who bought at 10% now has $100k of equity and is only paying $5k a year for his house when rates get to 5%.
I would never give anyone particular investment advice, but just keep this in mind and don't be a sucker. There are many interests in the national government, real estate brokerages, and home sellers themselves that want you to believe that buying at low interest rates is the way to wealth. If you keep this diary in mind when you are making such decisions (no matter the decision you come to), I will feel like I've done my job.
More here:
http://patrick.net/...