When I go to open houses or otherwise talk with Realtors about the housing market, one of their favorite arguments on the “buy now” front is that mortgage rates are still very low and I should think about buying before they go up. It’s a fairly common argument that gets thrown around on the real estate blogosphere, I saw it again here on BloodHoundBlog and it’s one that doesn’t seem to generate any disagreement, except on the hardcore bubble sites, despite the fact that it’s exactly 100% wrong.
But wait, you might be thinking, when rates are low I can afford to buy a higher priced house. Isn’t that a good thing? Don’t I want to buy when rates are as low as possible? I mean, if I buy a $400,000 house, I’ll have lower payments if I have a lower rate, right? That’s just simple math.
And the answer is, yes, that’s just simple math. But, in the real world, especially when we’re buying a house, the math gets a lot more complicated than that.
Let’s do the simple math first and see where it leads us. Imagine a couple, lets call them the Smiths, who are ready to buy a house. They make $100,000 a year between them, have a reasonable amount of money in the bank and not much in the way of outstanding debt. Old school metrics say you should spend no more than 28% of your income on housing. Since we’re all about the old school here at Home In Babylon, we’ll go with that and fudge a little upwards. Let’s say the most the Smiths can handle is about $2500 a month.
So, how much house can they buy with that money? According to this handy calculator, at 6% they can borrow a whopping $334K, while at 9% they can borrow only a meager $249K. “Aha!”, you say, “It’s obviously better for the Smiths if rates are lower, they can get spend more money and buy a better house.” Well, not really.
If you’re a fan of Saturday Night Live, you might remember Don Novello’s most famous creation, Father Guido Sarducci. Sarducci was a recurring character back in the early days of the show, but he still makes appearances from time. In my opinion, Sarducci’s best bit was something called “Five Minute University“. The premise of the bit was that he would open a university that would teach you everything that the average college graduate will still remember five years after graduation. His economics curriculum was simple and direct. What do you need to know about economics? Supply and demand. Simply remember that, and this next bit will make more sense.
OK, as we figured out, if the Smiths are out looking for a house when rates are at 6%, they can spend about $330,000 (plus down payment, etc.) for their new home. If they’re looking when rates are at 9%, they can only spend $250,000. The problem is that while the Smiths have more money to spend on a house when mortgage rates are low, so does everyone else. The Jones have more money. The Browns have more money. Everyone has more money to spend on housing. There’s more money out there chasing the same number of houses. So prices go up. Like Father Guido says, supply and demand.
This is the same exact thing that happened, only on steroids, during the big boom years from 2003 to 2006. During this period, when the Smiths would sit down with their loan officer, instead of choosing a nice, safe, 30 year fixed loan with a 6% rate, they might be offered a 2 year adjustable loan with a 4% teaser rate. Sure, their payments would go through the roof in two years, but in the meantime they’d be out there with $420,000 to spend on the house they really wanted instead of a measly $330,000 . Unfortunately for them, of course, so would everyone else. More money was injected into an already overheated market and prices exploded through the roof. So we found our good friends the Smiths buying the same house they might have bought before the teaser rate fairy granted everyone more cash to spend, only it cost them more money and put them at greater financial risk.
Well then, you might ask, why does it matter. As long as you plan wisely. whether rates are high or rates are low, the monthly payment you can hack is going to be about the same. Which is true, except that if you buy when rates are high, you can refinance when they drop and save yourself money. If you buy when rates are low, the bank isn’t going to forgive part of your debt when rates go up and home prices fall. Worse yet, if you have an unexpected event and have to sell you could lose your down payment and even end up having to pay the bank money at closing to get out from under the mortgage. This is the thing that keeps me up at night when I think about buying a house.
Of course, this is a very simplified exploration of a very complex subject. Home prices don’t track exactly with mortgage rates. Housing values are sticky, both on the way up and the way down (especially on the way down). Prices change slowly. They move one comp at a time and in a slow market like this the comps can be few and far between. Plus interest rates are only one factor in the complex computation of house pricing. Local economic conditions, national economic conditions, housing stock, area desirability and large number of other things too numerous to mention.
Still, when a Realtor spins the “buy now, while rates are low”, you might consider replying, “All things being equal, I think I’d rather pay more”.