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Price to Rate Buying Power

 
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FagerNasty
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PostPosted: Tue Dec 13, 2005 4:09 pm GMT    Post subject: Price to Rate Buying Power Reply with quote

Not that anyone here would ever consider buying a house at this point, but there may be a "decent" time to buy in the very near future. Considering that prices have begun to drop, the key is to time those drops with historically low interest rates. By my overly simplistic formula it appears that by buying today at the current housing price, you are paying the same per month as you would if rates were to rise by 0.75% and prices were to drop by 10%. If rates were to rise by 1.5%, or essentially to their historic average, and prices were to plunge by 20%, you would be paying the same per month as you would if you bought now.

Granted, you would be out a significant chunk of chage if you had to sell quickly for any reason, but over the lifetime of a 30-year mortgage, each 1/4 point rise in interest rate will cost ~$6K/$100K. For a $300K house and 1.5% higher interest rates, thats an extra $108K over the life of the loan. So, if you plan on living somewhere for 30-years, and you decide to buy after a 20% correction in housing prices, make sure you don't end up spending that savings on interest. The best possible scenario is to get in on something that has already been corrected for at a historically low interest rate.

Let me know if this makes sense or if I forgot to carry a zero Wink
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PostPosted: Thu Dec 15, 2005 4:09 pm GMT    Post subject: Reply with quote

if a 10 or 20% decline is coming best to wait until then and get a 15 year mortgage i think.
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PostPosted: Thu Dec 15, 2005 4:10 pm GMT    Post subject: Reply with quote

And also don't make the message board confirmation code case-sensative. Especially when all the letters are capital anyway!
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admin
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Joined: 14 Jul 2005
Posts: 1826
Location: Greater Boston

PostPosted: Thu Dec 15, 2005 6:10 pm GMT    Post subject: Reply with quote

Hi,

I think your numbers are off, but I'll get to that in a little since there are a few underlying assumptions which I think are more important to address.

One important implicit assumption is that the monthly payment is the only thing that matters when evaluating the price. While that might be true if it is 100% guaranteed that the place you are buying will be your best housing option for the next 30 years, the reality is that situations frequently force people to move (e.g., due to job relocation or changes in family size). In fact, the average period of time for owning a house in the US is 7 years. I would expect this to be exaggerated even further in metro areas like Boston where young people may have no options within their price range apart from condos but then upgrade to a home a few years later as their growing family necessitates and as their rising income allows. The point being, total price does matter when you sell before your loan is paid off and that is actually the norm in the US.

The size of your down payment also matters a great deal. If you have a large down payment, then changes in interest rates are much less relevant and total price is much more relevant.

It's unlikely that rates and prices will move in lock step since there are many other factors influencing price as well, and indeed you acknowledge this. Your hypothesis appears to be that sometime after whatever corrections are coming happen, prices and rates will settle back into an equilibrium similar to where they are at now such that monthly payments won't be substantially different, but that during the transition they may be out of step for awhile, and if prices adjust first, then it could create a good buying opportunity. While that is certainly a possibility, I would actually expect rates to move first since housing prices are stickier as prospective sellers are psychologically adverse to taking a nominal loss (which is not really rational, but that's a different topic). I also don't think that we will arrive back at an equilibrium similar to now because I think we are way out of equilibrium at the moment when you look at historical ratios of prices to incomes, rents, population growth, and inflation. Finally, just as irrational exuberance artificially inflates prices during years of plenty, irrational pessimism may artificially deflate prices once real estate loses its luster as the investment du jour, thereby reducing monthly payments despite higher interest rates. In fact, looking at what has happened historically, monthly payments have gone down in the past when total prices have fallen.

Regarding your numbers, I think that they are off for two main reasons. First and foremost, the sensitivity of what price you can afford does not vary linearly with changes in the interest rate. While your $6K approximation may be close enough for one or two quarter point adjustments around a rate of 7.5%, the errors become a lot more substantial when you start talking about 0.75% and 1.5% increases. The other important thing that should be considered is the down payment. The further the price drops, the further your down payment goes and the less you have to borrow as a percentage of the total sale price, which leads to another non-linear relationship that results in linear approximations failing to apply outside of a narrow range. As an extreme example, if you can put down 20% on a house now but decide to wait, if prices fall by 80%, then you won't need to borrow anything and the interest rate will not be relevant at all. I certainly don't think prices will fall 80%, I'm just using that as example to point out that as prices drop, the interest rate becomes less relevant if you had a substantial down payment from the start.

I re-ran the numbers taking these things into account. You can see the results at http://www.bostonbubble.com/interest_rate_sensitivity_20051215.html If rates return to their historical average by rising 1.5% (I haven't verified that and will assume you are correct), this would require a mere 11.08% decline in prices (instead of 20%) in order for the monthly payment to remain the same. I assumed that you would borrow $300K and put 20% down in order to buy a home now, which results in a down payment of $75K and a total price of $375K. I also assumed that you would put down the same $75K in the future and then calculated how far the total price would have to decline in order to make up for a given rate increase. I think that an 11% decline in prices is rather optimistic and that the actual decline could be substantially more, but the point is that if it is any more than that, then waiting pays off in this scenario. (Actually, the threshold should be even lower since you could park the $75K in I Bonds and earn 6.73% essentially risk free until the correction comes, so a full analysis would need to take the opportunity cost of the down payment into account. I'm sure there are other factors to consider as well.)

Feel free to double check my numbers as I could have made a mistake. I provided references on the chart, where applicable.

- admin

PS - To the guest who brought up the confirmation code, if you sign up for an account and use the account to post, you won't need to enter a confirmation code each time. FagerNasty, I recommend that you sign up for an account as well so that others can't spoof your name now that you've contributed many constructive posts.
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draculess
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PostPosted: Sat Dec 17, 2005 1:46 am GMT    Post subject: boston home prices Reply with quote

I see on boston.com

http://www.boston.com/realestate/news/articles/2005/12/09/sellers_chop_asking_prices_as_housing_market_slows/

then I go to bostonhomes.com and don't see any sellers dropping their prices.

No drop in Boston so far. Somrthing bad needs to happen first.
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admin
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Joined: 14 Jul 2005
Posts: 1826
Location: Greater Boston

PostPosted: Sat Dec 17, 2005 5:12 pm GMT    Post subject: Check Craigslist Reply with quote

The website theburstingbubble.com tracks the number of reduced listings on Craigslist by city. There is a graph for Boston at http://www.theburstingbubble.com/pages/charting.php?marketid=3 which shows Boston reductions and it looks like there are a lot, but the data doesn't seem to go back far enough to say whether the number of reductions is statistically significant. I would guess that they are since a year or two ago I think the prevailing impression was that reductions were unnecessary. Anyway, check out Craigslist if you want to see actual reductions.

- admin
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PostPosted: Mon Jan 02, 2006 3:46 pm GMT    Post subject: Reply with quote

You're using listings on Craigslist to trend price reductions? Are you a moron?
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admin
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PostPosted: Mon Jan 02, 2006 5:32 pm GMT    Post subject: Reply with quote

I am not doing that - it is on another website. I was merely pointing out to the poster who asked where the reductions are that there are some on Craigslist. In fact, I specifically stated that I didn't think the numbers themselves were statistically significant yet.

However, would you care to explain why it is that you think that using Craigslist as a crude market barometer is invalid? Craigslist is rapidly replacing the newspaper classifieds of old. If you wanted to study real estate trends of the past you would probably gain the most insight from studying the Registry of Deeds records in combination with the classifieds, so by extension it would make a lot of sense to study the current incarnation of what the classifieds have become (e.g., Craigslist).

- admin
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draculess
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PostPosted: Sat Jan 14, 2006 12:46 am GMT    Post subject: housing inventory Reply with quote

On the herald today, they say ppl are taking their houses off to resell
in the spring for a better price. I would like to see the sales statistics on the unrealistic prices of these houses with today's mortgage rates in spring of 2006.
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admin
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Joined: 14 Jul 2005
Posts: 1826
Location: Greater Boston

PostPosted: Sat Jan 14, 2006 1:59 am GMT    Post subject: Reply with quote

Hey draculess, thanks for the tip off. I've added a link for the Herald article you mentioned to the front page.

- admin
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ryanu



Joined: 26 Aug 2006
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Location: Mesa, AZ

PostPosted: Sun Aug 27, 2006 12:33 am GMT    Post subject: Reply with quote

Best to wait and get in a 15 year mortgage? Thats crazy talk.

http://www.themortgagereports.com/2006/02/the_fastest_way.html
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admin
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PostPosted: Sun Aug 27, 2006 2:10 pm GMT    Post subject: Reply with quote

Quote:
Best to wait and get in a 15 year mortgage? Thats crazy talk.


I believe that the main point of the anonymous guest you were referring to was the waiting to buy part and that the 15 year mortgage suggestion was only secondary.

Nevertheless, I took a look at the link that you gave which argues against a 15 year mortgage. The biggest problem with the argument is that it assumes an after tax interest rate on savings that exceeds the mortgage rate (with the tax advantage factored in). Bankrate.com currently lists the average 30 year mortgage at 5.96%. The best FDIC insured rate on savings (currently a 1 year CD) at BestCashCow.com is 5.68%. I believe, and correct me if I'm wrong, that the rates are directly comparable because if you are taxed at the marginal rate of X%, then the savings is X% of the rate whereas your money earned from savings will be taxed at X%, so both number would be reduced by X% and we therefore only need to look at which is greater. The mortgage interest rate of 5.96% is higher than the highest savings rate on a cash equivalent, so you would be losing money if you tried this interest rate arbitrage now. A better return on savings, while possible, would be quite difficult at present and would almost certainly involve additional effort and additional risk.

Another problem with the argument is the underlying implication that the interest rate deduction is fully and universally applicable. I realize that the article states that individual tax situations may change the applicability, but I think you should qualify your "crazy talk" assertion with "if you can take full advantage of the mortgage interest deduction and have been consistently achieving savings returns on cash at a higher rate than the mortgage interest rate." The problem is, the mortgage interest deduction is not useful to people with low incomes because the standard deduction is higher than itemizing and it is less useful to people with high incomes because it is phased out when your income exceeds a certain level. Also, if you would have otherwise taken the standard deduction, then your savings is only the difference between that and the itemized amount that you take with the interest deduction. There is only a sweet spot in the middle where the deduction is fully effective.

- admin
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