Timing the bottom – Comparing price declines and interest rates

Your life situation is changing. Maybe you are getting married or maybe there are kids on the way. You’ve been eyeing up a new house to accommodate the new situation, but you’ve been hesitant to buy because the real estate market has been struggling, and you’re worried about prices continuing to decline. Why should you buy a home priced at $500,000 today if there is a potential that the price might go down another 10% this year? You could then buy the home for $450,000. In today’s environment of super-low interest rates, the math isn’t that simple and you need to do some analysis of mortgage interest to see if buying today makes sense.

We are in unprecedented economic times and here is no way to accurately predict when the real estate market will turnaround. Real estate agents, so-called experts or economists who claim to have the answer are guessing as much as you and me. Personally I wouldn’t try to time the bottom of the market, because I can guarantee that timing the market is nearly impossible. What I can say with reasonable certainty is the following.

  1. Mortgage rates won’t stay this low – The federal government has been buying billions in mortgage-backed securities and treasuries in an effort to push mortgage rates to artificially low levels. This has driven mortgage rates to historic lows. (Today one of my mortgage reps was quoting under 4.5% for a conventional mortgage!) Eventually this stimulus of the mortgage market will give way to inflation concerns, and we will see mortgage rates tick up into the 5.5%-6.5% range where they were hovering before.
  2. We will reach the end of the cycle of real estate prices – The real estate market is cyclical, as evidenced by historical data. We will reach the end of price declines and likely see the market flatten out. It is impossible to predict when real estate prices will begin to rise again and how fast they will rise, but many predict that we will see prices in our area plateau by the end of 2009.

Given those two data points, let’s take a look at some mortgage scenarios for buying a house today. Assume for the moment that you are buying a home priced at $500,000 and have $100,000 to put towards a down payment. We’ll also assume that you take a full-amortized 30-year conventional loan, giving you the best rates available today. At a 4.75% interest rate, your monthly principal & interest payment would come out to $2086.

Purchase Price

$500,000

$477,865

$467,493

$457,554

$448,025

$438,887

Down Payment

$100,000

$100,000

$100,000

$100,000

$100,000

$100,000

Loan Amount

$400,000

$377,865

$367,493

$357,554

$348,025

$338,887

Interest Rate

4.75%

5.25%

5.50%

5.75%

6.00%

6.25%

Principal & Interest Payment

$2086

$2086

$2086

$2086

$2086

$2086

Decline in Purchase Price  

-4.4%

-6.5%

-8.5%

-10.4%

-12.2%

With such low interest rates today, plus knowing that interest rates will definitely increase over time, I’ve calculated out how much prices would need to drop to match the $2086 monthly payment we calculated above. If interest rates increase to 6.0%, the price of the home would have to drop by 10.4% to get the same mortgage payment that you would be able to get today at the low 4.75% rate.

Bottom line, today’s low mortgage rates allow you to buy more home for your money and potentially offset some potential price declines, allowing you to have more house for the same monthly payment. For this math to work, you do need to commit to living in your home for a number of years, preferably 5 or more, otherwise your mortgage savings and equity in the home can be eaten up by the transaction costs associated with selling your home.