Asymmetrical Information

An interesting question. I'm afraid we have little choice, however. It's not as bad in the DC area as it is for you there in Manhattan, but all but the wealthiest face the choice of either throwing half one's income away on rent or more than half on a mortage. The latter option generates equity and a tax deduction.

Well for one thing, lenders allow you to borrow more. It used to be that 33% of gross income could go to debt payments, now I think the rule of thumb is 41%.

Jane, if you are right and people start having trouble paying their mortgages, maybe some will band together and start a lawsuit against "Big Credit" for keeping them in debt and letting them bite off more than they can chew.

I think it also may be related to a phenomenon I've noticed among much poorer people as well. I have a friend who is a social worker, working mostly with single mothers on welfare. She tells me that many of them have apartments full of expensive furniture and electronic equipment that they buy with credit cards. Rather than looking at whether they can afford, say, a $2000 TV on their income, they look at whether they can afford the $39.99 monthly payment for that TV each month. They end up massively in debt because they fail to consider how much they're paying over the long term. Then, when they realize a few months later that all of their income is going towards paying off credit card debt, they complain that their checks aren't big enough, because they fail to make the connection between their choices to commit to spending more than they receive now and having to pay more than they can afford later. I think this is also how a lot of middle class families end up tens of thousands of dollars in debt.

I wouldn't be surprised if a lot of (especially first time) more affluent home buyers look at their situations the same way. Instead of looking at the long term, whether they can really afford to buy a $200,000 house based on what they make now, they look at whether they can afford the $1000 a month mortgage payment and don't give enough thought to the fact that they'll still be paying off that house in 20 years, when maybe they'll want the money for something else.

depends on your income prospects

and heh... pretty much everyone i know would love 1000 a month for a house that you could actually live in

course... it also depends on what you think of as middle class...

Personal savings as a percent of disposable personal income was 3.3% (as of June '03). In 2001, it was 2.3%, the lowest it's been since 1938. If you go to bea.doc.gov and look at the "Personal Income and Its Disposition" table, the savings rate seems to have been declining since around 1987. So the problem here goes beyond mortgages.

I think it's just so easy to go into debt these days that lots of people would rather borrow money than cut down their expenses.

1) To my limited knowledge, we have not had a 3-5% per year inflation or had similar pay raises to keep up with the cost of living. Inflation has been almost non-existent for years. Often times the pay raises were significantly in excess of 5% (In the mid-90s for example I received one 15% pay raise followed by a 10% pay raise the following year). Where did you get those numbers? Most of the items which have been on the rise have been raised within the last 18 months, and the basics, food, clothing (depending on where you are, shelter) have not increased significantly to my knowledge (I am not talking about NYC, Boston or San Francisco).

2) No one expects the Spanish Inquisition (or the great depression, or a deflationary economy). If we did, we would horde cash (in the form of gold doubloons) and would never invest in anything even the least bit risky. When you buy a house or an apartment you use the following calculation: How much money am I paying in rent RIGHT NOW. How much would I have to pay in maintenance/mortgage/expenses/etc? How much can I write off my taxes? How much extra will I have saved if something catastrophic happens? Catastrophic means anything from becoming unemployed to deflationary economies, but it is nothing more than an after thought. Here is the kicker of a question...How much will this cost me in 15 years...the same it's going to cost me now. In the history of economics there are far more times when inflation rises than when it falls. Over the short term a home buyer may be stuck...over the long term it's much more likely a home buyer will benefit.

3) As an almost home buyer myself I did not count on the same type of inflation my parents took advantage of, I counted on a status quo, which is really the only way anyone can make any investment. You can hope for a windfall and pray that no bad things happen, but a rational investor should be looking at the here and now.

The banks making the loans can make different assumptions about the future than consumers can. The big one is that the bank can assume that it can foreclose if the borrower defaults on the loan. But another slightly less obvious one is that the bank effectively self-insures by spreading the risk of default across a larger number of loans, often geographically dispersed. Even banks that write their own mortgages and hold them rather than selling them often do this by doing business in other cities in the states where they do business.

There is nothing nefarious about this in most cases. With only a few exceptions, banks do not make loans with the intention that any specific borrower will default. But they do have a very rational expectation that some will. Their tolerance for that percentage of defaults is very different from the experience of an individual borrower unable to make the payments. Thus, they are much less concerned about marginal borrowers than those marginal borrowers themselves should be.

What I can't answer is precisely the questions you are raising. Have the expectations of many borrowers been conditioned by two decades of rising real estate prices and inflation? Do they expect their incomes to rise and the real dollar value of the debt to fall rapidly enough for the debt to noticably diminish as a percentage of their income during the real life of the loan? (That is, while they own the house, which isn't as long as the term of the loan most of the time.) It seems clear that in some cases this has happened.

"but a rational investor should be looking at the here and now"

Or, a rational investor would look at a variety of barometers, including the p/e of housing, the recent credit explosion (of bubble, if you will), the recent performance of residential real estate versus the historic mean, the ratio of income (disposable and total) to home prices, the debt service burden of the typical household, and other barometers. Said "rational investor" may well be spooked by the real estate market, look at the early 70s, 80s, and 90s, and decide not to ignore the one component that many people miss in their analyses: The risk of buying a highly leveraged, illiquid, interest rate- sensitive investment.

Here on Florida's Space Coast, real estate is cheap. My wife and I bought our first home about 15 months ago. We were approved for 300K but spent about 102K on a 3bdrm 2bath, 1600 sqft. We just refinanced with an ARM, and pay about 680/month total. And we are only 10 minutes from the beach.

Jane:
As recent and fairly young homebuyers, I don't think that's necessarily the case. It certainly wasn't for us. That is, my husband and I are almost guaranteed yearly raises, but we didn't use that when figuring how much house we could afford. Knowing that money would be tight (and still is), the thought of a raise was nice - but we would have bought the house anyway.

James is right - the house we ended up with and the interest rate we got it at are such that we're paying around $100/month more than a comparable apartment. I'd rather stretch and get some money back someday than throw it away on rent.

Amy: I'm not sure I understand what you're saying about a house payment. Whether you can afford the monthly payment is what you have to consider. In addition - yeah, it sucks to make a 30 year committment on a loan. But what options are there?

Having contemplated buying a house myself, I have been debating this very point. There are conflicting viewpoints on the matter. Some (e.g. hedge fund investor Jim Rogers, columnist Jim Jubak over at MSN Money) expect the to increase the monetary supply to drive down the value of the dollar, and thus, eventually increase inflation, and pay off the Federal debt with cheaper dollars. Others point to the Fed's last 20 years or so of inflation fighting as indicitive of the fed policy. I can't decide which to believe, and whether I should be looking for a big mortgage (to be eroded by inflation) or a small one.

My gut is to go small. My problem is I live on the east coast where they pretty much only come in the "big" variety. Reading an article in the NY times a couple days ago spoke of two tracks for housing. The coastal track with limited supply has grown from 3 times the prices of flyover country to 6 times that in the last 20 years or so. At some point you gotta think that a correction is coming. Again, my gut says go small - but that would require moving.

I also think the throwing your money way on rent concept is false. Doesn't really matter if you pay the landlord or the banker unless the property is appreciating (or depreciating).

I'm not sure that inflation is really as low as reported. Check out the actual details of the CPI sometime. For example: increases in automobile costs due to more stringent emissions-control requirement are backed out...even if you are paying $500 more because of a better catalytic converter, that additional cost isn't included in the CPI (the theory being that the benefits must at least equal the cost, or the government wouldn't be requiring it). I wouldn't be surprised if there are lots of other dubious things to be found in there...

Dave: I think it's pretty simple--when rates go down, real estate prices go up. If this increase in the money supply causes inflation, and, indirectly, higher mortgage rates, I think we'll see prices fall precipitously, especially when you consider that just about everyone who can buy a house has bought one.

Dave: You don't think so? When you rent, you are 100% guaranteed to get nothing out of what you're renting. But when we sell our house - probably between 5 and 10 years from now - we will have equity. And, in all likelihood, a little appreciation as well - it isn't likely to depreciate.

And it's OURS:) That's the other thing.

Fixed?

Tom - on the one hand inflation will force rates up, and prices of levaraged assets down (foreclosures, etc). On the other hand inflation appplies to prices of homes (or at a minimum the commodities that go into homes if new building isn't overly restricted) which would push house prices up. That interplay creates an uneasiness that makes markets what they are (unpredictible). - That being said, if monetary policy is going to create a bunch of inflation, a fixed rate loan would enjoy the benefit of being repaid in cheaper, future dollars - regardless of whether the value of the house goes up or down. Its tricky stuff, which is why I am thinking about it a lot.

Demosthene - if the house neither appreciates or depreciates then dollars spent on rent or on interest (net of deduction) will be equally spent with nothing in return to you. Either way you are buying a service - either the service of a roof, or the service of using some one else's money. Neither service accrues any future benefits.

The dollars you spend to paydown the principal will certainly be equity. From that position, your assumption is that it will appreciate also - I merely point out that it is an assumption, even if it is a likely one. No guarantees in life, though. And promises to repay borrowed money should be a considered choice.

Granted though - it is yours, and that is a different, (presumably satisfying) experience.

I would postulate that in a cooling or contracting economy, inflation in consumer goods will lead to deflation in housing costs.

First, land will become cheaper as its owners need liquidity, and the wealthy landowner will be enticed by higher bond rates.

Second, as the economy continues to stagnate, labor will be cheaper as the demand for renovations and new construction will have contracted.

Last, with nondiscretionary income dropping, consumers will have less to spend on a nicer house, because they'll be spending more on gasoline, chicken, and health insurance.

Having bought and sold a house in the last year, I don't think the average homeowner wannabe is thinking about inflation over the next 5 years. They are thinking if they don't buy this year, it will be more expensive next year. Here in the DC market - that seems to be true. Also - in a practical sense, homes are not assets for the typical homeowner until they sell them. While they are living there - the house is an expense. Again, I'm speaking practically - GAAP would require us to record the house as an assett and the mortgage as a liability, but most homeownes aren't having the family budget audited by Deloitte, so we don't care.

An alternate explanation of high hoursing prices: it's always been a good idea to buy instead of rent because of the tax deduction, right? Well, obviously, it just can't be the tax deduction; if everyone could it, renting and buying would have the same return. Everyone didn't use to be able to buy a home, though; large sections of society were either redlined out, credit-risked out, what have you. If that's increasingly less true, you'd expect the price of housing to be bid up a bit, while renting falls.

"even if you are paying $500 more because of a better catalytic converter, that additional cost isn't included in the CPI (the theory being that the benefits must at least equal the cost, or the government wouldn't be requiring it)."

What kind of damn fool theory is that? If the benefit was at least equal to the cost, from the consumer's standpoint, the government wouldn't have to require it!

And since when do we just assume that the government only does things whose overall benefits are worth the cost? I don't see any basis for that sort of blanket assumption.

"Dave: You don't think so? When you rent, you are 100% guaranteed to get nothing out of what you're renting."

And when you buy, you take a chance that you'll end up having to sell at a loss. Sometimes it's worth it, sometimes not.

The theory (in the catalytic converter case) seems to be that the benefits are diffused...I benefit from your catalytic converter and you benefit from mine. Just to be perfectly clear, I am not advocating this theory as a way of calculating the CPI...I am pointing out that this is evidently the way it is *actually done*.

By the same logic...if the government required all auto companies to continuously dig gigantic holes in the ground, and then to continuously fill them in...then the additional auto cost attributable to the digging and filling would be subtracted out and not be considered as part of the "true" price of the car.

The dollars you spend to paydown the principal will certainly be equity. From that position, your assumption is that it will appreciate also [...]

Or at least that it won't depreciate much.

They are thinking if they don't buy this year, it will be more expensive next year. Here in the DC market - that seems to be true.

That's why I own a house a year earlier than I intended to. I watched housing prices in my DC suburb rise 23% in one year and decided I'd never own a house here if I didn't jump in.

Another financial advantage to owning a home that nobody's mentioned yet is that you can put sweat equity into it. I do expect my home to appreciate, but I'm not just sitting around waiting, either.

Here's more info on the CPI treatment of emissions controls for cars. Looks like they started backing them out in 1971, but reversed course and stopped doing so in 1999. I'd argue that this is 28 years of data which is at least somewhat misleading.

http://www.bls.gov/cpi/cpitreat.htm

It would be great if someone would really dig into the CPI calculation methodology.

A quick spin around google puts a converter for a new Honda Civic at $150; that's between 1.25% and .83% the price of a new Honda Civic, depending on model. Cars are about 10% of the CPI, so we're talking one-eighth to one-twelfth of one percent of the consumer goods basket.

On the other hand, the rest of the Honda has improved in leaps and bounds over it's 1971 counterpart. So just looking at the price of "a Honda Civic" is going to OVERESTIMATE inflation.

DeLong's book (http://www.j-bradford-delong.net/TCEH/Slouch_title.html) Slouching Towards Utopia goes into this in some detail.

I think that the costs attributed to the emissions control went way beyond the catalytic converter per se...

Over the years my wife and I have paid off two mortgages. We've also rented out s house on a couple of occasions, and I quickly found out why rents are pretty near as high as mortgages. Unless you get to pick your tenants very, very carefully, you'll have a whole lot of damage to repair after they move out. If they stop paying rent, it takes months to evict them - and they'll really trash the place meanwhile. I would assume that these problems get easier higher up the scale, but you've still got people who have nothing invested in the building living in it. They may be nicer, but there's no guarantees about their kids. (The worst juvenile delinquent in the small town where I grew up was the mayor's son...)

A minor point: buying and selling a house involve significant transaction fees. You really need your house to appreciate around 10% to break even on the sale.

At least with the changes in the tax law, you don't have to pay capital gains tax on a gain that (historically) is mostly inflation.

While it's obviously true that holders of long term fixed rate debt benefit from inflation, I don't believe most home owners take that possibility into account in buying a home. We certainly haven't on any of the houses my wife and I have bought over the years. The general rule has been - what can we afford now?

In considering the possibility of inflation though, I'd like to see an analysis of the composition of governement debt - maturity levels, fixed rate vs floating, how inflation will impact the unfunded liabilities. This would make a fascinating post and give us some insight as to how easy or difficult it might be for the US govt to inflate it's way out of debt.

I suspect that given the changes to the composition of long term debt that Rubin put in place, COLAs for Social Security, etc... that the Federal government will not benefit from inflation. California on the other hand...

First time on this site and I love the way you fellas think. Transaction costs in buying a house are huge in my opinion as noted in an earlier post.

Also, it seems to me with the increases to the standard deduction, the tax advantages of owning get somewhat riddled away. Granted a lot of high income earners can get over the standard deduction with state income taxes.

It's definitely a lifestyle decision, however. I'm a single guy in his twenties who wants to be able to move if I need to and not pay $10,000 in expense to do so.

Great discussion you've provoked Jane! My two cents: once a week, I hear someone say "you know house prices always go up so you should be willing to overspend"... so yes, I do think house price appreciation is now strongly embedded in consumer psychology.

You may have noticed that mortgage demand has plummeted since rates have backed up 150 basis points over the last two months. We'll see how quickly this takes to translate through into lower house prices and, gasp, humbled homeowners.

One final tangent: lower housing prices would be a great sword to wield against incumbent candidates, since at least some of the back-up in rates can be attributed to the avalanching budget deficit.

Whatever the conditions are today, remember that one constant is change.

I can remember news stories about the "wage-price spiral" in the 60's and 70's when the Unions went on strike on a schedule demanding outrageous pay hikes that astounded the rest of us.

The stagflation of the 70's and 80's. The high inflation and high interest rates.

I recall seeing news stories in the 90's of how Greenspan and Rubin had conquered the business cycle and made recessions a thing of the past.

One thing I learned from all this is that there ain't nothin' that lasts. This trick is figuring out when it's going to change and which way.

I doubt that low inflation is here to stay any more that the Internet bubble or stagflation.

Another consideration is that most mortgage lenders require PMI for buyers with less than 20% equity in their home. This means that if the borrower defaults on their debt, the lender
is covered and the cost of defaulting is carried by the PMI, most payments being made by people who won't default on their loans.

My original mortgage lender didn't want to release me from PMI after my equity went above 20% of the loan, so I simply refinanced, which lowered my payment as well as eliminating the 80$/month that went to PMI. It seems to indicate to me how much the mortgage lenders like PMI, and that there are probably a lot of people who are paying it when they don't need to do so.

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