Thursday, July 30, 2009

More on Capital Traps, Buying, Holding and Selling Housing

Readers checked in with diverse responses to this week's entry on houses as capital traps.

Readers found a number of holes in Housing Recovery: Sell Now Or Your Capital Will Be Trapped (July 27, 2009). To wit: if you can buy a house with a 3.5% down payment FHA loan, that modest amount is in effect an "option" that the fixed-rate mortgage will continue to cost less than rent.

Matthew C.

I have read your blog often over the last couple years and I am always impressed by your sharp analysis, not to mention that your charts and graphs are excellent, which back up your analysis.

However, upon reading your recent article, I think you are missing a very important piece of the puzzle. People buying a home today will NOT be trapped. In fact, now is a great time to buy because of the possibility of rising rates.


I live in San Diego County and bought my first house in 2002 for $220,000. After becoming convinced that we were in a speculative bubble, I sold this house in the summer of 2005 for $385,000. I rented for 3 years and just bought my second house this April for $450,000 (would have been $700K+ at the peak).

Here is the scenario:

3.5% down = $15,750 minus $8,000 Obama tax credit = $7,750 down.

Seller paid all closing costs per contract.

FHA loan at 4.75%, 30 year fixed. Payment with taxes, insurance and MIP = $3,047.66.

Now here are my options under your scenario:

Rates go way up (in your example 4.5% to 9%). Now I can sell my house with my ASSUMABLE FHA MORTGAGE at 4.75% for more than market value and use the money to buy a new house at true market value while keeping my payments the same and getting a much bigger tax deduction due to my higher interest rate on the new home. Furthermore, FHA purchase loans are non-recourse, so I could walk away anytime if I ever owed more than the home was worth. By the way, if anyone says that is wrong, I say BS, because I am paying mortgage insurance (MIP) for that very reason.

Not to mention, I am paying $3,000 a month for a house that would rent for the very same amount and I am getting a huge tax deduction in the process. I also locked my payment at $3,000 a month for 30 years versus rents that will go up with the coming inflation you describe.

Not to mention, my $7,750 is a pretty cheap “option” on my home considering that if the price does increase (due to inflation), my return on investment could be huge. A $77,500 increase in value would be a 1,000% return on my money. Of course I am not counting monthly payments; but why should I when the rent would be the same as my payment and I have to live somewhere anyway. Not to mention I am actually getting by cheaper per month because of the tax deduction.

I agree that I would have been a fool for buying in 2005 when I actually sold my first home.

But on the same token, I would be a fool for renting right now when I can buy a house for the same as renting and give myself a non-recourse loan and a massive tax deduction. Furthermore, because the loan is assumable, I won’t be trapped. In fact, I will be delighted to sell my home for more than market value, only to purchase another bigger and better home with the proceeds. And if the sales price is less than I paid (because of rising interest rates), EVEN BETTER, because now I will have a capital loss to offset future capital gains, all the while buying another bigger better house with a lower property tax base and an even bigger mortgage deduction due to the higher future interest rates.

Do you see anything wrong with my analysis?

I forgot to mention how the “assumable” works with FHA loans.

The new buyer just has to qualify based on income. They DO NOT have to pay the MIP which you already paid and NO new appraisal is required.

They just take over the loan and you walk. The other terms are per contract and can be whatever the buyer and seller agree to. It is super easy and clean.

So the bottom line is: Minimum down payment FHA loan is the way to go in today’s market. Here is a Q and A on FHA loans (I just typed in “FHA loans are assumable” on Google and clicked the first link.)

Excellent points, Matthew, and my only comment is that I should have specified I was addressing people who had large equity positions in their home--potentially trapped capital--and even more specifically, a large percentage of their net worth tied up in their house. In other words, those for whom a drop in house value would be catastrophic to their overall net worth.

Buying a house with 3.5% down is certainly a sound strategy if the overall monthly cost of ownership is relatively fixed and on par with local rents. But there's no capital to be trapped in that scenario, only the modest "option."

The assumable FHA loan could well be a major advantage; if the loan is fixed at say 5% and interest rates rise to 9%, then selling a house with the 5% mortgage (assuming the buyer qualifies for FHA financing) would be far easier than selling the house to a buyer who must finance the purchase at 9% with a conventional 20% down payment.

And all this assumes the Federal government will continue to have the means to subsidize the housing market with unlimited FHA loans.

Richard H.M.

Housing Recovery: Sell Now Or Your Capital Will Be Trapped is 100% correct and right-on. I came of age after the collapse in the 70's and saw the same thing from a different point of view: House prices HAVE TO be low when interest rates are INSANE!

You did a bang up job of explaining of how we get there from here, back to those low prices with insane interest rates.

I'm a financial guy, so easy to read your article.

To explain it to Joe Six Pack: When your ARM explodes, no one else will want your house, either.

To explain it to Goldbugs: Avg home has historically sold for 100 oz. of the yellow stuff. So houses are still way overpriced today, by about 2 to 1.

I grew up with Depression era Dad who taught me to pay cash for everything. By the time I started owning houses (never a mortgage), I looked at homes as "stuff you own" like your pots & pans and collection of old Beatles albums.

Actually, it's worse than that, more like a car... there are endless taxes, fees and maintenance costs, and as the deferred maintenance accumulates, you are likely to have a lower residual value, like a used car.

The only houses that seem to really appreciate are in high end neighborhoods where the owners constantly renovate. When you subtract all the costs of keeping your home in perfect condition and constantly remodeled and "updated"... still, not much of an investment.

The real catch-22 is that in boom times, there is nothing for rent in the exclusive neighborhood, and in hard times, when there are rentals available, then the neighborhood doesn't seem so exclusive anymore.

We have a block called "foreclosure gulch" right in the middle of Reno's most exclusive established gated community. Was fine until the real estate market peaked, then it quickly became a block full of bank REO's, short sales, and half finished remodels abandoned by spec. builders and left with a pile of liens and loans that no one will touch. And that's Reno's BEST neighborhood.

Bill C.

I am with you on just about every point except one. If inflation kicks in won’t that lift the stock market rather than have it fall? Coincidentally, won’t cash be devalued as inflation rises, like Zimbabwe?

Excellent point, Bill. What gets confusing is whether we actually get inflation or not, or if we get modest inflation but much higher interest rates. The worst case is also possible-- prices deflate AND interest rates rise because there's so little cash in the world (surplus capital) and too much demand (govts, business and people wanting to borrow). I guess we'll just have to to wait and see which we get. If we get high inflation, then you're absolutely right, cash will lose value (purchasing power) unless interest rates rise faster than inflation--which is also possible.

Greg R.

RE: Home Equity being trapped.

At one point you suggest, selling your home and putting the equity into a savings account in a rising inflationary economy, so the equity is not trapped.

Is that really a good thing to do?

If I did that, I would no longer have a home and have to rent. Monthly Rents in my area exceed the monthly mortgage cost for the same home. With a fixed mortgage I have limited my monthly housing costs, something I cannot do with renting in an inflationary period. I lose the ability to deduct the interest portion of my loan, but then that is mostly offset by having to pay property taxes. My money is in a savings account with fixed interest, in an environment with rising inflation.

In rising inflation investment returns rarely meet or exceed inflation itself, which means I'm now losing money on that former equity.

You haven't convinced me that selling my home and removing the equity is a sound decision.

If I had investment property, I might consider what you've suggested, as it would allow liquid funds to be quickly placed into gold until inflation blows over.

I bought my home in 1983 for $98,500 with 25% down and a mortgage of 13.25% (remember prime interest rates were 9%+) My mortgage payment in 1983 was was about $920/month; I refi'd three times since then. I'm now in the last few years of a 15yr loan at 5.25% with a monthly payment of $484/month My home's value peaked in 2006 at $640,000, It's now going for $440,000.

Like I said If I had investment property I might be inclined to bail, well actually I would have in 2006-7 as I've felt for 5-6 years that this economy was unsustainable and heading for a fall.

My property taxes are limited under Calif prop 13 to 1.5% annual increases.

I guess one issue here is comparable rents; if the costs of owning are fixed and lower than rents, then that is a major positive as inflation could drive rents higher. On the other hand, if vacancies rise due to foreclosures, poor economy, etc., then rents could fall even in an era of modest inflation.

As noted above, there is no reason why interest rates could not double even as the economy remains in a deflationary period.

I should have stressed in the "capital trap" entry that a key issue is how much of one's total net worth is in a single property. If essentially all of one's capital is in a house, then the eventual value of that house dictates the value of one's entire worth. That is a big gamble in a global economy which is falling apart at the seams.

Deon N.

Nice piece on the "Housing Recovery". I enjoy your perspective, insight and original thinking.

On a related note with regards to rising interest rates and lower home prices, one very little discussed topic is what I call "impact of capital".

In other words, in a higher interest rate environment capital (cash) has a higher impact on principal sums. Quite simply using your "Interest Rate See-Saw" example, let's suppose a buyer gives a $125K down payment on the the $500K purchase price. This $125K represents 25% of the total amount. In a high interest rate environment, citing your $250K purchase price, the same $125K down payment would represent a whopping 50% of the total amount. But that's not it, the real impact of capital is that every extra dollar put in towards the balance of principal($125K balance) represents over 100% more "impact of capital" than in the current low interest rate environment (original $500K purchase price). This is because every dollar represents a higher percentage towards the lower principal amount, (purchase price of $250k vs $500K). Although obvious, nobody really brings this fact up in the mainstream media.

The ramifications of this "impact of capital" are huge and becomes even more significant over the long term as the principal is reduced.

Thank you, readers, for your valuable input on this big topic.

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