Why Low Rates are NOT a Reason to Buy

In the comment section over at Marin Bubble a reader asks the following question:

The new RE agent spin seems to be about the interest rates.

I'm trying to sort out the reality of the situation.

They are saying that even if home prices continue to fall, the interest rates will rise.

So, obviously, now is the best time to buy.

Has anybody done the math on this?

Yes interest rates are at historic lows as the graph above shows. Does that mean it's a good time to buy?

Put simply, no.

Interest rates will be going up. And that does change the math. For example, if you were to buy a $300,000 home with $60,000 down (20%) today with rates around 5%, this would mean a monthly payment of $1,640 including taxes and insurance.

Conversely, if you were to buy a $300,000 home with $60,000 in 1981 with mortgage rates over 18%, this would mean a monthly payment of over $4000.

Quite a difference. For those that remember the early 80s they'll recall that there were not many homes being sold for $300,000.

And that is exactly the point. People won’t be able to afford $300,000 homes anymore, let alone homes priced at $2 million. So home prices will be coming down.

Now ask yourself, in such an environment would it be a good idea to buy now and lock in the low rate, or wait until prices decline and pay a higher one. THE KEY THING TO REMEMBER IS THAT AS MONTHLY PAYMENTS ADJUST WITH INTEREST RATE CHANGES, HOME PRICES WILL ADJUST TO REFLECT AFFORDABLE MONTHLY PAYMENTS.

An easy way to look at it is to use the extreme numbers above. Would you rather A) put down $60,000 on a $300,000 home and pay 5% (payment of $1640/month) or B) put down $60,000 on a $160,000 home and pay 18% (payment of $1650/month).

In situation “A” you'll be underwater when rates go up, lose your down-payment/equity, be unable to relocate if you find a new job, and unable to refinance into a lower rate mortgage (you already timed the bottom thanks to your Realtor’s advice). But hey, at least you locked in that low rate.

In situation “B” you'll own nearly 40% of your home right off the bat, if rates go down you can refinance your mortgage and get a lower payment, you'll have no problem selling if you need to relocate, and you've locked in a low property tax rate (thanks Prop. 13) off the initial sale.

I’d take option “B”, but maybe that's just me.

But how can you be so sure that rates are going up?

Answer: Because Ben Bernanke told me so.

Here is the Chairman of the Federal Reserve on 60 Minutes a few weeks ago:

Asked if it's tax money the Fed is spending, Bernanke said, "It's not tax money. The banks have accounts with the Fed, much the same way that you have an account in a commercial bank. So, to lend to a bank, we simply use the computer to mark up the size of the account that they have with the Fed. It's much more akin to printing money than it is to borrowing."

"You've been printing money?" Pelley asked.

"Well, effectively," Bernanke said. "And we need to do that, because our economy is very weak and inflation is very low. When the economy begins to recover, that will be the time that we need to unwind those programs, raise interest rates, reduce the money supply, and make sure that we have a recovery that does not involve inflation."

Which brings us back to the early 80s. Why were interest rates so high in 1981? Because then Chairman of the Federal Reserve Paul Volker's policy was to “raise interest rates, reduce the money supply” to make sure we lived in a world that did “not involve inflation”.

Inflation is a result of too much money. To get money out of the system, as Bernanke explains, the Fed has to raise interest rates (or, more precisely, sell assets taking cash out of the system). What concerns me about the current situation is that in the history of the Federal Reserve we've never seen so much money put into the economy by the Fed.

Take a look at this graph that dates back to 1918:


This is truly unprecedented, and quite frankly, scary. What's worse is this is just the beginning. So far the monetary base (which the Fed controls) has grown from around $900 billion to $2 trillion. If you add up all the programs the Fed has promised it will grow to ~$4 trillion. Some expect this to eventually be over $5 trillion.

All this money is going to cause inflation (which means higher interest rates) unless the Fed can take the money out of the system quickly (which means higher interest rates). If you look at the numbers Bernanke is going to have to pull off a Volker on steroids.

If that doesn't get us the taxpayer via the Treasury is going to be making up the difference. That could get people questioning the solvency of the U.S. government (which like an ARM gets most of its funding from short-term bonds and is susceptible to higher rates). Higher risk means higher interest rates.

You get the picture.

Moral of the story: when a Realtor claims you need to buy now and lock in low rates, ask them if real estate prices will continue to fall if rates go up. Wouldn't it be better if I used my hard earned down payment towards a lower priced home and then refinance down the road?

I'll be polite and assume they simply haven't thought it through yet and will quickly change their tune.