The pending real-estate market collapse

I am not a financial advisor or a real estate expert, but that's not going to keep me from spouting off and predicting an impending crisis in the real estate market. I do, after all, know a thing or two about math, and I don't like the numbers I'm seeing.

The problem is low interest rates. It looks like rates are on the increase, and this can prove disastrous.

Mortgage rates have been at historical lows for several years now. A five-year fixed-rate mortgage can be had for about 5%. If you can keep that interest rate for the next 25 years, you could repay a $240,000 loan for about $1400/month over the 25 years. That makes a $240,000+ house surprisingly affordable, even for some first-time home buyers.

However, if mortgage rates climb to just 7%, the monthly payment over 25 years jumps to $1700 - an increase of more than 20%. Could you afford such an increase? When was the last time you got a 20% raise?

Put another way, the $1400 monthly payment that would repay a $240,000 loan at 5% interest, would repay only a $198,000 loan at 7% interest. That's a huge decline in the value of your home. Remember, a home buyer doesn't care about the price tag, but how much they can afford to pay each month toward their mortgage. It doesn't matter if it's $240,000 at 5% interest, or $198,000 at 7% interest: it's still $1400/month to repay the mortgage over 25 years. As interest rates go up, two things happen: the same monthly payment buys less house, and home prices go down. If you can't afford to keep your house and decide to sell it, you will probably not get back what you put into it.

So you decide to keep the house and ride it out? Then let me put it yet another way. At 7% interest, that $1400/month covers only the interest on the $240,000 mortgage - you would never repay any of the loan, ever. You must come up with more money each month ($300/month more, to be exact), or sell your house at a loss. You don't even have the option of amortizing over a longer term, because your $1400/month is only covering interest at this point.

There will also be a ripple effect on the economy. With more money spent servicing a mortgage, people will have less income left over to spend on dinners out, high-definition TV sets, and kitchen renovations. That new car will have to wait another year, and you'll vacation in your back yard instead of Hawaii this year. With corporate profits down, the stock market will decline. Seeing a decline in revenue, and unable to raise working capital through a public share offering, some companies will be forced to lay off workers to reduce costs (further putting pressure on home prices; it will become a buyer's market as people are forced to sell their homes, because it's difficult to repay a mortgage when you're unemployed).

So what's the solution?

Responsibility.

Live within your means. Don't be lulled by low interest rates into buying more house than you can afford. Instead, look at this as an opportunity to repay your mortgage more quickly. (Simply figure out how much you would pay each month at 7% interest, and pay that amount back even when the current interest rate is 5%.) Most people pay off their house in 25 to 30 years. How would you like to own yours outright in 15 to 20 years instead?

Think long term. Even in an uncertain real estate market, it's nearly always better to buy than to rent. My message here is not to discourage you from buying a house, but to make you aware that your monthly payments will be considerably higher if interest rates rise.

Invest in yourself. If you come into unexpected money (a bonus at work, an inheritance, or that mining company whose stock you bought suddenly strikes gold), don't waste it on a frivolous things. Use it to make a lump-sum payment toward the outstanding principal on your mortgage. That way, you reduce the impact of higher interest rates on your actual debt amount. And if you get a raise that is higher than the cost of living, consider adding the difference to your monthly payment.

People always seem to blame others when they fall on hard times. Here is one problem that you can anticipate for yourself. If you believe, as I do, that interest rates are headed up, be careful and plan ahead. Don't bite off more than you can chew.

Comments

Deb said…
You have been getting into some seriously deep subjects lately. I need a fluff item that I can make fun of.
Sassan Sanei said…
I thought I did that with the Tweety post. :)
Anonymous said…
For anyone interested in better understanding finances (as they relate to personal responsibility), I highly recommend:

Your Money or Your Life: Transforming Your Relationship with Money and Achieving Financial Independence

--by Joe Dominguez, Vicki Robin

I read it many, many years ago and it helped me immeasurably.

The basic idea of the book is to encourage you think of money as life energy. That craptacular item you just bought cost you X number of hours of your life (working, commuting, etc.) If you hate your job (as I did at the time I read it), it turns you into a total cheapskate because you can't bear the thought of wasting any more of your life working to buy more crap.

The end result (for me and my wife) many years later is that we work for ourselves, make less money, enjoy our lives more, own much less crap, and have zero debt--but it all took some time to accomplish.

Keep up the good, thoughtful writing.
ahhh, most wise sassan.

there was a property market crash here in oz a few yaers ago - lucky enough for me i sold my property before, just at the peak. but it's a huge responsibility that requires you to look ahead and most people don't.
Laura said…
How much you pay in interest vs principal actually changes over the life of your mortgage, so whether you can afford to 'ride it out' or not depends on how long you've held it. In the beginning, your payments mostly go towards interest, while towards the end of your mortgage your payments mostly go towards the principal. Try it for yourself here: http://www.amortization-calc.com/.

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