In a land far, far away rests a place where homes are bought with 20% down and mortgage rates hover around 8%. In this world, we also have moderate credit growth and a government making a decent effort at decreasing budget deficits. In this mythical world, people try an antiquated concept of spending less than they earn. Welcome to the world of the Financially Prudent.
Somehow in the last few years, we’ve had this mortgage rate fixation that seems to be the dominating tour de force in all things economic. If Ben Bernanke hints at a rate decrease the markets get all excited and stocks go up like hot air balloons in
We are still at record low mortgage rates. Take a look at the historical 30 year mortgage:
Somehow the threat of a .25 increase sends the market into a tornado of dark mysterious destruction. But what does this truly say about our economy? What it implies is that we are codependent on low rates to sustain the economic growth we’ve experienced. What it also implies is our addiction to credit. When rates increase the money supply contracts and this leads to scarcer credit. In addition, with record low savings rate and the imprudent approach to the down payment, you can now finance your entire home purchase and even get cash back. Cash back you say? It may be a little harder to do this now given market sentiment but this was commonplace just a few years ago. In fact, we had loans with 125% loan-to-value ratios. Buy a house and get $50,000 in your pocket. No wonder why we are enjoying a 70% record home ownership rate. There is one small and infinitesimal caveat, you need to pay the money back! Somehow folks felt that they bolted on a silver Diebold ATM to the side of their house and any equity in the palace was earmarked for vacations, remodels, paying higher credit card debt, or buying a car. Otherwise the home was ground zero for our consumption economy and has kept it afloat after the 9/11 attacks.
Let us take a look at another chart, the Fed rate chart:
As you can see from above, we nearly went to zero percent in 2003. Think about what this means. Banks have fractional reserves with the Fed banks. The lower the Fed rate, the more they can borrow and lend out. Since fractional reserve banking isn’t one-2-one, any drop in rates means an exponential growth in the money supply. And with lax underwriting standards and the foreign debt appetite, we were able to finance nearly anything in our economy. There are many dense economic books talking about monetary policy but suffice it to say that anything below 3% for all intents is viewed by and large as free money. We hovered below 3% for 3 years! It was like an orgy of credit; images of Scrooge swimming in gold coins and $100 green bills come to mind.
Yet we forgot one thing in all this free money. Rates only encourage spending or stifle spending. Sound economic policy is based on monitoring credit expansion. Of course asking the wolves to mind the hen house isn’t the smartest thing, this is the policy we have been following since the start of the millennium. But for consumers, rates do not matter. The first thing you learn in real estate investing is location, location, location. Okay, lesson one is finished. But the second paramount thing to understand is you become successful by the purchase price of the home.
Rates Do Not Matter!
This fixation on the monthly payment I’m starting to find is based in behavioral economics and psychology. Everything is boiled down to the monthly payment.
“ReplayTV for only $39.99 a month!”
“Cell phone family plans for only $69.99 a month!”
“Enjoy credit protection for $19.99 a month.”
“Your interest-only payment for $1,600 a month.”
Sound familiar? When was the last time you heard an ad for “cell phone family plans for $840 a year?” How do you eat an elephant? One bite at a time. How do you bamboozle the public? Apparently by breaking everything down to the monthly payment.
Ironically this only works with spending and not savings. Why not save this much a month in your 401(K)? Why not sock away 10% a month for 30 years and be a millionaire like every self-help financial books discusses? Psychologically spending and saving are processed differently. They are diametrically opposed. If you spend $5 you cannot save that same $5. Marketing companies have honed into this message and have it down to a science. But again, the monthly amount does not matter, it is the price of the item.
Let us take a look at two scenarios for a home. We’ll use two different scenarios to point this out.
Los Angeles Home
$500,000 Purchase Price
20% Down = $100,000
Current Rate and Terms: 6%
Monthly Payment (taxes, insurance, principle) = $2,820
Los Angeles Home (20% Drop)
$400,000 Purchase Price
20% Down = $80,000
Future Rate and Terms: 8% (closer to historical average)
Monthly Payment (taxes, insurance, principle) = $2,680
So not only do you save $20,000 on your down payment but you are also saving $140 a month on your payment. The above scenario is very likely. The reason I highlight this is because many lenders and brokers are trying to scare clients about the boogie man of interest rates. Give me a cheaper house with a higher interest rate any time. You want higher mortgage rates? You can’t handle higher rates! So the mortgage industry would like you to believe.
Subscribe to Dr. Housing Bubble’s Blog to get more housing content and your full dose of Real Homes of Genius.