It is *not* a good time to buy a home

Yup. That’s right. It is not a good time to buy a home, at least in California. “But housing prices seem to have bottomed!”, you say, and “interest rates are at historic lows!” Well, allow me to explain.

Because, homes are so expensive in California, people tend to buy as much house as they can afford; the yardstick for “affordability” being the payment. The price of the home they can “afford” is, thus, driven by two main factors: the payment they can afford and the interest rate. (I’m ignoring the down payment since that will vary wildly from person to person.) All things being equal, the payment people can afford is a constant at any point in time. This is particularly true if financial institutions learn their lesson and stop the loose credit practices that got us into this mess in the first place (i.e., ARMs, interest only, no-doc, etc.). My feeling is that, at least in the short-term, a borrower’s true ability to pay will be evaluated much more stringently.

Currently, mortgage rates are artificially low because the government is trying to encourage banks to lend to help the economy. Rates without government intervention would be much higher. Think about it: credit/loans are much harder to come by these days. In other words, the supply of money is low. So what normally happens when the supply of something shrinks? Well, the cost goes up and for loans the price is interest rates.

The government cannot keep rates low forever and there are many reasons why. The primary reason is inflation. Eventually inflation will start to rear its ugly head. The Fed will be forced to increase rates because keeping them low will only fuel inflation. My guess is that this will not happen for a year or maybe a few years, but it *is* going to happen. As the economy recovers, it is inevitable. Also, the government may have to start paying higher interest rates on the trillions of dollars of debt it is now trying to sell. If the rates on T-bills/bonds goes up, guess what? Overall rates go up.

When rates go up, the amount of the loan people can afford goes down. Naturally, this will put downward pressure on home prices. Now, although it is theoretically possible that rates will rise gradually and not cause issues, I don’t believe that is likely. Rates are likely to jump quickly because of being artificially held down like a rubber band being released before it breaks. The effect will be devastating to the real estate market.

Still arent’ convinced interest rates will affect real estate that much? Consider this: the payment on a $500,000 loan at 4.5% is about $2,500. If rates climbed to just 8%–still low by historical standards–the loan would have to be about $350,000 to maintain the same payment! That’s a 30% decline! At 12%, the amount dives to $250,000, at 50% decline! And don’t even think that’s impossible. A few decades ago, rates above 20% were common.

For me, I am ignoring the fact that interest rates are at historic lows. It’s artificial. I would rather pay 8% and owe only $350,000 than pay 4.5% and own $500,000. If rates came down, I could refinance. The person with the $500,000 loan is stuck.

Previously, I had thought that rising interest rates was going to be the catalyst for the bursting of the real estate bubble. I was wrong there. The actual cause was the rapid realization that mortgage-backed instruments weren’t really secured by the underlying assets. Still, as I’ve set forth above, the impact of rising interest rates still looms.

Special thanks to the Irvine Housing blog, whose recent post, got my blogging juices going and reminded me of my thoughts.