Friday, June 15, 2007

Mortgage Advice: Rates, Home Prices and Opportunity Costs

Homebuyers rely on Realtors and Mortgage Professionals to help them understand the connection between Purchase Price and Interest Rates and how they relate to time.  The Time Value of Money can be easily interpreted by Real Estate professionals that do a little math to show people the Opportunity Costs of choosing to buy or not to buy.

People are astonished when they ask me about the market and I say "It is a GREAT time to buy"... it isn't a sales pitch, it is the truth.

What factors do I feel prove this statement?

  • Prices are DOWN
  • Rates are LOW
  • Inventory is HIGH
  • Days on Market is HIGH

All of these factors show that this is a GREAT time to buy.

But what if Mr. and Mrs. Homebuyer still want to wait?  What if they say, "well, everyone keeps saying the market will drop another 1-2% so I think I'll hold off until then!"

That's when I talk to them about Opportunity Cost... the cost of NOT buying now.  The cost of passing up a property that they would love and can afford to wait for a future time when:

  • That house may not be available
  • Prices in that market may not go down
  • Rates will go up
  • There may not be a house available that fits their needs as well in the future

So you see that there are many variables, many unknowns, that could create greater costs if you wait until the future.  

Surely, waiting increases the chance of that "1-2% drop" happening if the market is in a downturn...but the benefit of that 1-2% on a purchase can be seriously outweighed by the greater costs of any of the other variables.

The questions that homebuyers must ask themselves are:

  • Is this the right house? 
  • Is it a house we love?
  • Does it fit our needs now and for the foreseeable future? 
  • Will we be able to find another house like it if we pass now?
  • What is our legitimate timeframe for buying?
  • And most importantly - Will we be able to afford this house if the mortgage payment rises? 

Other opportunity costs to factor are:

  • Lost appreciation on a more expensive house if mortgage rates rise
  • Costs to shop for a home
  • Tightening in Lenders Underwriting policies about Loan to Value, Asset and Income, and ratios
  • Prolonging of escrows based on sale contingencies
  • Carrying costs of current house/rental while shopping

Robert D. Ashby, CMPS wrote a post called Realtors, You should be scared right now! where he detailed what these recent weeks of rising rates can do to your buyer's home purchase budget.

I have taken it a step further with the table below (click graphic for full size table in new window):

 As you can see, there is a lot more detailed calculations that can help your buyer determine if now is the right time to buy. 

  • One of these calculations is simply the amount of house the buyer is qualified to buy based on a interest rate hike of .75%. 

    As you can see.  The Interest Rate goes from 6.00% to 6.75% in this equation.  The payments are identical, but the buyer now can no longer afford a house for $375,000 and the new budget is set at $346,250.  The $28,750 could mean sacrificing on distance to work, distance to schools, amenities in the community, an extra bathroom, square footage, etc.
  • Another Calculation I have drawn out is the lost appreciation over time. This table shows an average of 5% appreciation over 10 years. 

    As most homeowners are in their homes for 4-5 years, I have broken this table into two time frames for examples - 5 and 10 year cycles.  Obviously, the lesser priced house cannot appreciate as much over time as the larger home. 

    At Year 5, you can see that the more expensive home has yielded an additional $13,343 in appreciation over the less expensive home.  This is a Direct Opportunity Cost of waiting in a volatile market. 

    Over 10 years, the difference in appreciation triples to $39,041!!  Essentially, for the same monthly payment, the asset returned an additional 10% over 10 years! 

This illustration shows the real future value of money lost due to the higher interest rate. (click graphic for full size table in new window)

  • This shows that same 0.75% interest rate increase actually costs an additional $8,829 if the homebuyer chose to wait and got the house at the same price but with a higher interest rate!

Another calculation that should be considered in this discussion is "What if the market drops another 2%??"

In this table you can see that the original property price is on top with its 30 year Fixed Rate at 6.00% payment of $1,799.

If you drop down to the other three rows, you see that they are all 2% less in property value than the first value. 

  • As you can see, 2% is only $36 in difference in the payments if the rate is the same. 

    So if there is no negotiating under the current value of the home, this would be considered Today's Value.  If you were to wait until the price dropped due to economic changes, time on market, seller urgency and finally get it down, you're gambling over $36.
  • Now, should the value of the property drop 2%, but the interest rate goes up just 1/8 or 0.125%, the payment difference becomes only $13. 

    So now we're rolling the dice on the wait over a couple days worth of Starbucks.
  • Should the value drop 2% but the rate goes up 1/4 or 0.25% (recently we've seen an increase of 0.50%!) then the payment amount goes up and is now $11 MORE... so there is a LOSS of $11 for waiting on property values to drop by $7,500.

Now you can see how two of the main ways to calculate Opportunity Costs as they pertain to Buyers stalling in the current market.  As you can see, both of these are Quantitative.  The Qualitative factors are harder to calculate but should not be forgotten.  They can be:

  • scarcity in a community,
  • scarcity of the model,
  • quality of houses in a price range,
  • longer commutes,
  • community amenities,
  • model amenities,
  • building materials,
  • quality of finishes,
  • inferiority of lots,
  • etc.

Now, the next time you hear "Oh I think you should wait for the market to totally bottom out" or "I think there's 2% more drop in the house values in this state" remember we're talking a few dollars a month difference versus tens of thousands of dollars difference in payments.

More Florida Mortgage and Real Estate News You Can Use From
David A. Podgursky, MBA
The Mortgage Go To Guy
Your Source for Residential, Commercial, Investment and Relocation Mortgages in Florida

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