Planning to buy a house? Read this.

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switters's picture
switters
Status: Platinum Member (Offline)
Joined: Jul 19 2008
Posts: 744
Planning to buy a house? Read this.

I came across this reader comment on Charles Hugh Smith's blog in response to one of Charles' recent posts.  In that post, Charles argued that buying a home is a very bad idea in this market because it's a liquidity trap.  Several readers wrote in with dissenting views, and this one stood out.

I have read your blog often over the last couple years and I am always impressed by your sharp analysis, not to mention that your charts and graphs are excellent, which back up your analysis.


However, upon reading your recent article, I think you are missing a very important piece of the puzzle. People buying a home today will NOT be trapped. In fact, now is a great time to buy because of the possibility of rising rates.

Here is my proof: (MORE THAN 40% OF HOME PURCHASES IN 2009 ARE EXPECTED TO BE COMPLETED WITH AN FHA LOAN).

I live in San Diego County and bought my first house in 2002 for $220,000. After becoming convinced that we were in a speculative bubble, I sold this house in the summer of 2005 for $385,000. I rented for 3 years and just bought my second house this April for $450,000 (would have been $700K+ at the peak).

Here is the scenario:

3.5% down = $15,750 minus $8,000 Obama tax credit = $7,750 down.

Seller paid all closing costs per contract.

FHA loan at 4.75%, 30 year fixed. Payment with taxes, insurance and MIP = $3,047.66.

Now here are my options under your scenario:

Rates go way up (in your example 4.5% to 9%). Now I can sell my house with my ASSUMABLE FHA MORTGAGE at 4.75% for more than market value and use the money to buy a new house at true market value while keeping my payments the same and getting a much bigger tax deduction due to my higher interest rate on the new home. Furthermore, FHA purchase loans are non-recourse, so I could walk away anytime if I ever owed more than the home was worth. By the way, if anyone says that is wrong, I say BS, because I am paying mortgage insurance (MIP) for that very reason.

Not to mention, I am paying $3,000 a month for a house that would rent for the very same amount and I am getting a huge tax deduction in the process. I also locked my payment at $3,000 a month for 30 years versus rents that will go up with the coming inflation you describe.

Not to mention, my $7,750 is a pretty cheap “option” on my home considering that if the price does increase (due to inflation), my return on investment could be huge. A $77,500 increase in value would be a 1,000% return on my money. Of course I am not counting monthly payments; but why should I when the rent would be the same as my payment and I have to live somewhere anyway. Not to mention I am actually getting by cheaper per month because of the tax deduction.

I agree that I would have been a fool for buying in 2005 when I actually sold my first home.

But on the same token, I would be a fool for renting right now when I can buy a house for the same as renting and give myself a non-recourse loan and a massive tax deduction. Furthermore, because the loan is assumable, I won’t be trapped. In fact, I will be delighted to sell my home for more than market value, only to purchase another bigger and better home with the proceeds. And if the sales price is less than I paid (because of rising interest rates), EVEN BETTER, because now I will have a capital loss to offset future capital gains, all the while buying another bigger better house with a lower property tax base and an even bigger mortgage deduction due to the higher future interest rates.

Do you see anything wrong with my analysis?

I forgot to mention how the “assumable” works with FHA loans.

The new buyer just has to qualify based on income. They DO NOT have to pay the MIP which you already paid and NO new appraisal is required.

They just take over the loan and you walk. The other terms are per contract and can be whatever the buyer and seller agree to. It is super easy and clean.

So the bottom line is: Minimum down payment FHA loan is the way to go in today’s market. Here is a Q and A on FHA loans (I just typed in “FHA loans are assumable” on Google and clicked the first link.)

I suppose the only disadvantage to this approach is that the price of home you could potentially afford will be lower, because you'll be putting less down.  But perhaps that is worth the added flexibility and peace of mind a low down payment with an FHA-assumable mortgage would provide.  In a rising interest rate environment, even if the price of your house falls you could sell it for more than market value (because of your assumable lower interest rate mortgage), or you could walk away (because it's non-recourse) and only lost your small down payment.

Meanwhile, all of that money you would have invested as a down payment is free to be invested in precious metals, solar panels, durable goods, or whatever else makes sense.

This makes a lot of sense to me as a potential homebuyer in the next few years.  Am I missing something?  Can anyone poke holes in this approach? 

johnbryson's picture
johnbryson
Status: Bronze Member (Offline)
Joined: Aug 13 2008
Posts: 54
Re: Planning to buy a house? Read this.

But wouldn't increases in interest rates reduce the value of the house? If interest rates go up, mortgage payments go up, and fewer people are able to afford housing - so house prices forceably decline given the lower demand for housing. The opposite happened in the last 10 years. Interest rates went down and prices went up - as more people were able to afford the mortgage payments.

Morpheus's picture
Morpheus
Status: Diamond Member (Offline)
Joined: Dec 27 2008
Posts: 1200
Re: Planning to buy a house? Read this.

You have to be able to keep your job to afford a home. That's reason number 1 for waiting.

switters's picture
switters
Status: Platinum Member (Offline)
Joined: Jul 19 2008
Posts: 744
Re: Planning to buy a house? Read this.
johnbryson wrote:

But wouldn't increases in interest rates reduce the value of the house? If interest rates go up, mortgage payments go up, and fewer people are able to afford housing - so house prices forceably decline given the lower demand for housing. The opposite happened in the last 10 years. Interest rates went down and prices went up - as more people were able to afford the mortgage payments.

Yes, interest rates would reduce the value of the home.  But, if you have an assumable FHA mortgage with a lower interest rate, you'll be able to sell your house for higher than market value and possibly make up the difference.  For example, say you bought the house for $100,000 with a 4.75% interest rate.  Two years later, interest rates are at 9% and the value of the house has dropped to $50,000.

The monthly payment on both houses is approximately the same ($500 vs. $400).  Someone will be willing to pay more than the market value in order to assume that 4.75% loan, especially if they have money to put down - which will further reduce their monthly payment.  (This reflects the rising impact of capital in a high interest rate environment).

Speaking of the rising impact of capital in a high interest rate environment... if I sell the house for roughly what I paid for it, my down payment will go a lot further in a market where houses that were worth $100,000 are now worth $50,000.  If I put $20,000 down on that $100k house, I still have an $80,000 mortgage.  But if I re-invest that $20,000 into a $50,000 house, I've taken a much larger chunk out of the principal.  Even at higher interest rates, my monthly payment will be significantly lower.  And of course I'll be able to write-off a larger amount of interest each year.

 

 

switters's picture
switters
Status: Platinum Member (Offline)
Joined: Jul 19 2008
Posts: 744
Re: Planning to buy a house? Read this.
Morpheus wrote:

You have to be able to keep your job to afford a home. That's reason number 1 for waiting.

I'll need a place to live no matter what.  So the question is whether it makes more sense to rent or own that place.  If I can own for 3% down and can walk away from the loan (non-recourse, mortgage insurance) anytime my equity goes negative, then the only thing I'd lose in that scenario is my small down payment.  As the author of the comment I included in my original post said, it's like an option on the house. On the other hand, if inflation kicks in and housing values go up again (which I'm not counting on anytime soon, but could happen eventually), that "option" could appreciate significantly.  

Kman's picture
Kman
Status: Bronze Member (Offline)
Joined: Jan 19 2009
Posts: 72
Re: Planning to buy a house? Read this.

The assumption that house value are directly related to interest rates is overly simplistic.  Interest rates are a factor, but not the only one.  There have been periods of time when house values have increased as interest rates have gone up.  One measure to look at is the affordability index.  It tracks the percentage of people that can afford a median home in a given area.  Affordability is a combination of house prices, interest rates, and incomes.  However, affordability ratios are not fixed.  They vary significantly with market sentiment.  At CA peak, affordability had dropped to an all time low of 14%.  Now in many areas it is over 40%.  So, for example if interest rates went up today, it would not mean housing prices would have to drop- affordability could drop instead.  Its ultimately a factor of what people are willing to pay, not what they can pay.  Even in todays economy, its conceivable that if interest rates when up, prices would hold, at least initially as buyers on the sidelines panic and jump in to not lose out.  Longer term, when reality of the economy sets in, interest rate hikes would be likely to drive prices down.  However, if inflation takes off and those with liquidity look for assets, who knows what will happen to housing prices....

Kman

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