If rising interest rates causes the Real Estate Bubble to pop, will you be any better off waiting to buy?

I believe many regions in America are experiencing a period of Real Estate overvaluation.  Call it a Real Estate Bubble if you want.  With maybe a few exceptions, I don't think we are at those levels.  If you own a house, I am not recommending that you sell and try to get back in at lower prices.  But if you don't currently own a home (like me), should you buy now?

Plenty of pundits have pontificated that the only scenario in which real estate is likely to decline in value is a significant rise in interest rates, or a decline in local employment.  The latter is too regionalized, and also not what I want to talk about.  So, let's talk about interest rates.

Let's put some numbers on this hypothetical.

Let's say you are looking at a place for $550,000.  That's probably a 1,400 square foot, three bedroom condo in a good neighborhood around here.  Let's assume a 30 year fixed rate mortgage.  According to bankrate.com, the average 30 year fixed jumbo mortgage rate is 6.40%.  Assuming you came up with a 20% down payment $110,000, your mortgage payment, not including taxes and insurance would be $2,752.23.

Now let's say interest rates rise, ending the easy money train, and causing real estate prices to fall.  How much they might go down is completely unknown, and varies by region.  So, let's say it goes down 20%.  It's a fair estimate given the magnitude of the run up in prices in some areas.  You can now buy the same place for $440,000.  So, your 20% down payment is now $88,000.  But don't forget what prompted this.  An increase in mortgage rates.  So, let's say the average 30 year fixed jumbo mortgage is 8.6825%.  Now, oddly enough, this lower price and the higher rate results in the same mortgage payment!  Okay, so I tweaked the mortgage rate until I got the payment that I wanted.  The results are still very realistic.

By the way, the smaller mortgage would not require jumbo rates, allowing for potentially lower mortgage rates, but we'll let that slide.

The net result is that your monthly outlay will be the same.  It doesn't matter right?  Buy now at high prices/low rates or buy later at not as high prices/not as low rates, your monthly payment is the same, thus there is no advantage either way.

Wrong.

There are specific advantages to the latter scenario.

1. There's the issue of the smaller down payment.  The $22,000 difference could be used to make a larger down payment, reducing the monthly cost.  It can furnish your luxurious two bedroom condo, or it can be saved/invested.  This is opportunity cost.  The earnings you could have had from your $22,000.
2. Property taxes.  I don't own a home, so I don't know all the ins and outs of this.  But, my understanding is that most property taxes are roughly 1% of the initial assessment, potentially increasing every year depending on the rising value of the property.  However, California has a law called Prop 13, that limits the annual increases to 2% per year.  If your state has something similar, it is certainly in your best interest to start that calculator as low as possible.
3. Income Taxes.  The entire mortgage payment is not tax deductible (unless you have an interest only), just the interest portion.  So, despite the equal payments, you will pay about $2440 more in interest for the house in the second scenario.  This doesn't sound like a good thing, but it is.  That means a larger income tax deduction.
4. Refinance.  If you pay less, but have a higher rate and rates subsequently decline again, you can always refinance your loan.  If you pay too much, but have a low rate mortgage and prices decline you can't ask the seller to give you back your money.
5. Accelerated payments.  Many of us more frugal savers would like to be able to add extra payments to our mortgage to pay the loan down faster.  If you follow the bi-weekly mortgage payment plan, or increase your payment by 8.33% to $2981.58, which is the same thing, you will pay your mortgage off in 291 months in the first scenario.  With the same payment in the second case, you will have the loan paid off in 268 months.  That's almost two years.  Why does this happen?  Because the extra payment goes to principal, and there's less principal to be paid down.

Bottom line:  I'm not telling you not to buy a house right now.  I do not know where real estate prices or mortgage rates are headed.  This is a very personal decision, but do not be fooled into believing that if prices drop because of a rise in mortgage rates, there's no difference.  There's a huge difference.

Comments

[financial freedumb]

Interesting post...I'm really tired right now, so if I'm not making sense, just ignore this post...I'm getting confused by, "I'm not telling you not to buy a house right now." If there are advantages to the latter scenario of waiting for prices to drop, then wouldn't it be better to wait to buy a house?

[lamoneyguy]

Well, if you knew with near certainty that prices were dropping and rates were going up, I would tell you not to buy. But we don't know that with any certainty.

So, caveat emptor.

[Debt Free]

Trying to time entry and exiting a flucuating market is very difficult. More often than not, you'll be better off holding on to your property instead of trying to sell it and reenter the market later.

[lamoneyguy]

DF, absolutely. I would never advise it. This article was aimed at non-homeowners who are thinking, "even if prices go down, rates are going up, so there's no difference." My main point is that there certainly is a difference.

[Cecilia]

Excellent points! The 1% property tax is a general rule of thumb. What I have found out is that, with all the miscellaneous fees, taxes, and bonds, the property tax bill is closer to 1.5%.

[moominoid]

The key massive difference is that if you buy when prices are high then they are likely to fall. If you buy after prices have fallen they are likely to go up. So it is clearly optimal to buy after the crash even if a mortgage is more expensive. This is besides the other points you discuss.

[frugal]

This is a great analysis. I am planning to put up a more quantitative analysis on the same topic later. I think, in respect to an investment point of view, you don't want to buy in something that won't rise in value, UNLESS it is cheaper to buy than to rent. I have both cash flow analysis calculator and Rent vs Buy calculator on my site. Check it out.

[The Paranoid Investor]

Nice analysis, I have been explaining this to my friends for a while now. The other interesting thing is that most of us are payment buyers. If you can afford the payment you'll do it (generally). So it is really funny to see people jumping on the bandwagon the last few years to buy the same house with the same payment years earlier. Incomes didn't move that much, the only thing was interest and greed (and probably some other stuff). The other difference is person who bought at the hire price has a larger mortgage, it is real money that is owed, so they owe more on the same house.

[Ed]

Your point about the mortgage income tax deduction is based on a common mistake. Yes, you get a bigger tax deduction if you pay more interest - but on net you're still paying more money. It's never beneficial to pay an extra $1 of interest just to get $0.26 off your taxes.

[lamoneyguy]

Ed, I see your point, however in this hypothetical, you have two equal mortgage payments, one of which gets a larger deduction because a larger portion of that payment is going to interest. This is a good thing.

If you were paying out a larger amount in order to get that deduction, I would agree with you, but you aren't. The assumption here is that the payment would be the same.

[fatbear]

Good analysis, but one nit and an overall comment:

Nit - CA sets 1% for RE Tax; back east (NY et alia) taxes are set on an appraised value, which is independent of sale price per se - it's a valuation arrived at by comparing all real estate in the taxable area and evaluating it by use of non-specific price info, i.e., the value of all equally situated and improved homes should be roughly the same, despite great variations in sale price across the time scale

Overall - The payment theory is used by the RE industry as a way of getting buyers to go beyond their means; it is always far better to buy when prices have declined. The correct analysis (which I think is your "latter" version) is therefore that waiting to buy is the right way - it will probably get you a better house for the constant payment, as the price decline will most likely go beyond the calculated advantage (prices always overcorrect at some point, either down or up), with the chance of capital gains to boot. It all depends on your specific market, especially those in which speculators have been responsible for 30-40% of recent new unit purchases - as they suffer, there will be great deals on condos and houses - go to San Diego and you'll see the start of that sort of shakeout.

[Walter]

In response to the response to Ed's comment. Presumably, in the first scenario, the extra 2440 goes to equity, which I expect to get back dollar for dollar at some point. Paying interest, I get back, say, 0.28 * $2440 = $683 in tax deduction. To my way of thinking, I'm down 1757 long term.

[Brett Morgan]

If you purchased a $550,000 house with $110,000 down, and the market value for the house drops to $440,000, the bank is in a position to demand that you immediately front up with $88,000, because your net equity in the house is now zero. Buying a house is highly leveraged bet that house prices will go up.

[Martin Alak]

The "deducting interest" argument also assumes that you will pay enough interest - or have enough other combined with other deductions - to exceed your standard deduction. And even still, the part that is in leiu of your standard deduction can't really be counted, can it?

[Stephane Grenier]

Hi,

Good article. Almost a year ago now I wrote a similar article except that I calculated by just how much prices would have to drop as interest rates increased, and plotted them on a graph. The title of the article is "How interest rates can drastically affect real estate prices" and the link is: http://www.followsteph.com/?p=54. I suspect that you'll find it very interesting seeing as you wrote this article. The quick gist of it is that prices will drop significantly with minor interest rate increases. A quick good rule of thumb is expect a 6-9% decrease in price for every percentage point interest rates increase!

[Stephane Grenier]

I didn't realize you could post direct links in your comments. Please find the link to the article above here: How interest rates can drastically affect real estate prices.

[lamoneyguy]

Ed, Walter, Martin,
Read my follow up post

[loosenut]

It goes without saying that it is better to hold off in an overheated market. The last thing you need is to be in a house that's not worth what you still owe on it. This is only okay if you can accept risking complete and utter financial devastation that will take years to recover from (and years more of renting while you rebuild your credit).

What would happen if you take your two scenarios and toss in a move/relocation after 5 years? Fairly typical scenario, divorce/job-loss/health issue, or just simply wanting to move "up". I think that might illuminate some real distinctions in the two scenarios.

[Frugal]

There seems to be another frugal commenting. I don't know whether it was my writing, but it does lead to my site. In any case, I would say that it's better to wait even when the mortgage payment will be the same. This is because that in the meantime, your potential down payment can still earn either bank interest or investment return. Why the rush, if you can get the same age of house later for the same mortgage payment. I have a Buy vs Rent calculator and Housing evaluator at my site www.1stMillionAt33.com/finance-calculators
You can experiment all kinds of scenarios for yourself, whether rent increases, or housing market stagnates, etc. Just put in your own assumption to find out.

[tallguyindc]

Good point.

I am one of the market timers that sold and rented. I normally advise against market timing, but this is definitely an exception. I want you to think about my logic and respond.

One of the assumptions that people use against my strategy is that it is somehow inherently better to own. I disagree. From a living standpoint, I think they are both the same. Either way, I get to use the place in the exact same way. If I wanted to paint the place purple, I might be better off owning, but the truth of the matter is that my landlord lets me do whatever I want. Ownership comes with an investment, that renting doesn't. Because of recent gains, a lot of people think it is always a good investment. I disagree for reasons I will outline. Apart from the investment portion, owning is undeniably more expensive right now. If you look at all of the interest, tax, insurance and maintenance expenses, it is often twice as expensive or more. I'm not planning on owning until owning is cheaper. In the long term, it is normally cheaper. I suspect it will return to normal eventually. However, if I have to pay rent for twenty years at half the cost of ownership, it wouldn't be a great loss.

In order for renting to be more expensive than ownership, rents must rise significantly or ownership costs must fall. I don't see the former as a likely possibility. Take a look around at all the construction sites. Look at all of the people going into real estate investment. Its ultimately a supply and demand thing. Supply is going up far faster than demand.

Ownership costs will fall as interest rates rise. Your analysis was dead-on. However, it did lack the chicken and egg analysis that I consider most important to a crash. Interest rates will also rise as prices fall.

We have never seen a market this inflated because the rules have never been this lax before. The standard used to be 20% down. That is extremely rare these days. Quite a few people have int. only ARMs with very low equity. What happens when prices take a small fall? They default. What happens to those houses? The mortgage company sells them at a loss. What does this do? In addition to lowering house prices even more, it causes the mortgage investors to get in trouble. How do they respond to the increased risk? They raise interest rates and tighten lending standards. What does this do to the housing market? It causes a drop in demand and pushes even more people into foreclosure. At this point the process repeats itself and homeowners and mortgage companies find themselves in a death spiral.

As all of these houses come on the market, who do you think will be buying them? There are three types of homebuyers: Investors, movers, and first-timers. Most R.E. investors will not be in the market for buying new homes. They will already be in bankruptcy. They will be trying desperately to offload the houses they already own. Movers will be trapped. If you can't buy a new house without selling your old house for a $100k loss, you can't buy a new house. First-time homeowners will be in a very good situation. There will be some good bargains there. Many won't confirm to the mortgage companies new guidelines. Quite a few others might still pass the opportunity.First-timers are typically very naive and open to suggestion. Its like flying right after a string of crashes. Its cheaper and safer than ever, but its still difficult to find customers. What do you get when you rapidly decrease potential buyers at the same time you rapidly increase supply?

Your analysis was correct, but why did you stop at 8.68%? Its still low historically. Why did you stop at $440,000? Its still pretty high. Prices don't rise and interest rates don't fall in a vacuum. What happens next?

The downward spiral won't last forever. Eventually, owning will be a lot cheaper than renting. Guess who will be making a move back into the ownership market.

[Byron Raum]

It's a stupid "point." It only takes into consideration what happens today, and assumes that I will be staying in the same house for the rest of the mortgage. If this is true, then yes. However, do you expect to stay in the same place for 30 years? No? Then that means that you will end up $110,000 short when you try to move. Furthermore paying more interest is BAD, no matter whether interest is a tax write-off or not. If I pay an extra dollar in interest and write it off, I am still paying more than 2/3rds of that interest. Unless you despise the IRS with such a great passion that you are willing to lose 67c in order to make sure they don't get 33c.

[lamoneyguy]

Byron,
Did you read the follow up post? It amazes me how many people do not understand this point. You are not paying more money, simply a larger percent of your payment is going towards deductible interest. This is true whether you hold the house for 5 years or thirty. At the end of the first year, your total outlay is exactly the same, but you may deduct $2440 more on the cheaper house at higher rates. How has this cost you 67c? Mortgage = $2752.23 in both cases. Where did I lose money? In fact, by paying less, I avoided losing money.

Which point, exactly, was stupid?

[Mortgage broker]

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[Cow_tipping]

Also remember in a down market, you may lose $$ on the sale of your old house, but buying a bigger and better one will be cheaper. A lot of people hold on to their old house with a death grip ... unless they get the price they want ... and they back out of buying anything else.
Cool.
Cow_tipping.