PhilMur's thoughts on biz/tech/money/life

Recently a certain line of thinking has been promoted by realtors and other various professionals primarily in the real estate and mortgage community.  The idea is this: an increase in mortgage interest rates can be much more unpredictable, and at times more devastating, than an increase in home prices… so stop waiting, buy NOW while interest rates are low!

A good example of this type of messaging can be found in this article just published by the NY Times.  I also received an e-mail from a friend of mine recently who works as a realtor who was essentially making the same argument.

While their logic is not entirely flawed, those who encourage the purchase of a home NOW rather than later in this manner are really only taking into account two factors – interest rates and home values.  But in a home purchase decision, there are a variety of other factors involved that should be taken into consideration.

From a financial perspective, probably the most important other factor would be the amount of down payment a home buyer has ready as they buy a house.  I performed an analysis below where I demonstrate that if a prospective home buyer does NOT have a substantial down payment to bring to the table but, at the advice of the real estate gurus in the market rushes to buy a home now in order to take advantage of stellar interest rates, what happens?  Well, in that case their monthly payment and total amount paid for the home will be HIGHER than if they had waited to save a 20% down payment and suffered a 1% higher interest rate as a result of waiting.

Examine this chart closely, which takes a hypothetical look at the purchase of a $200,000 home in various down payment and interest rate scenarios:

Scenario 1 represents a buyer who rushes to buy a house in order to take advantage of current low interest rates (which are around 5%), but buys the house with little down (5% in this example, likely the minimum down payment their bank required).  It is the most expensive option on the chart, as illustrated by the highlighting of the payments/costs in red.  The least expensive option is Scenario 3 — by all means, take advantage of lower interest rates now if you do have a substantial down payment saved up (20% in this example).  But note that Scenario 2 assumes the worst with interest rates — a full 1% increase, something that recently hasn’t happened very quickly — and yet demonstrates a strong 20% down payment on the part of the home buyer.  And yet Scenario 2 leads to a lower monthly payment and total home cost than Scenario 1.  My point is proven!

There are two other factors to consider that I believe make my case even stronger:

1. Although 5% is a common current conventional 30-year mortgage rate, a higher rate would normally be charged for a non-conventional loan (a loan with less than a 20% down payment), and/or mortgage protection insurance would be required by the lender, making the home buyer’s cost even higher, further reducing the benefit of the lower rate they are receiving.
2. The higher the cost/value of the home, the LARGER the gap grows and the MORE advantageous it becomes to save up a down payment INSTEAD OF jumping in now with little down payment but at a lower interest rate.  Above, the difference in the 15-year mortgage monthly payment in Scenario 2 is $153/month ($1,503 minus $1,350).  But purchase of a $300,000 home, with the same percentage down payment and interest rate assumptions, will increase that gap to $229/month!

Although unrelated to the down payment issue, I think it’s also important to point out that my chart (for simplicity’s sake) assumes the same interest rate for a 15-year and 30-year mortgage, even though in reality you can get about a 0.60% LOWER interest rate on a 15-year mortgage than on a 30-year mortgage.

I hope that I have sufficiently demonstrated that one must tread carefully when taking the advice of the real estate community in regards to the timing of when you should you buy a house as it relates to interest rates, home prices, etc.  When do I think someone should buy a house?  Outside of home market price considerations, my answer would be to buy when they have saved up a substantial down payment and have demonstrated by doing so that they can live within their means and afford the monthly payment of the house they wish to purchase.

For a more exhaustive treatment of the argument behind saving up a substantial down payment, see my blog post “Saving for a home down payment: 4 BENEFITS”.