The amount invested in a house, equal to the sale price less the loan amount.
The House Investment Decision: Lenders impose the upper limit on how much a household can spend for a house. When borrowers push the limit, it becomes costly because such borrowers are viewed as more risky to the lender. Small down payments require a higher interest rate or mortgage insurance.
Does a household accumulate more wealth over time by pushing its buying power to the limit? While such an aggressive policy involves taking on more debt at a higher cost, it also generates larger capital gains—3% appreciation on a $200,000 house is twice as much as 3% on a $100,000 house.
Consider two buyers who both have $20,000 in cash, enough income to meet all lender requirements, are in the same tax bracket, and can borrow at 7% for 30 years and zero points. However, one is “aggressive,” purchasing a $150,000 house, borrowing $130,000 and paying a mortgage insurance premium of .53% for 10 years. The other buyer is “cautious,” purchasing a $100,000 house and borrowing $80,000, thus avoiding mortgage insurance. Which buyer accumulates more wealth over time?
The major component of wealth is the value of the house. This is affected by the assumed rate of price appreciation. Higher price appreciation benefits the aggressive buyer more than the cautious one.
From this must be deducted the balance of the mortgage. Both the rapidity with which the loan balance is reduced and the size of the monthly mortgage payment are affected by the mortgage interest rate. Since the aggressive buyer borrows more than the cautious buyer, higher mortgage rates hurt the aggressive buyer more than the cautious buyer.
We must also deduct the amount paid each month for interest, principal reduction, mortgage insurance, and the lost interest on this amount. This is affected by the assumed “investment rate,” which is the rate the buyers could have earned if they invested this money elsewhere. Since the monthly payments are larger for the aggressive buyer, higher investment rates hurt the aggressive buyer more than the cautious buyer. On the other hand, interest is tax deductible so that higher tax rates work in the opposite direction.
The tables below show how long it takes, if ever, for the greater price appreciation enjoyed by the aggressive buyer to offset the
effects of the higher costs. For example, if the investment rate is 5% and the buyers are in the 15% tax bracket, the aggressive buyer never catches up if the appreciation rate is 5% or less. At a 6% rate of appreciation, the aggressive buyer catches up in 25 years. Shifting to a tax rate of 35%, the aggressive buyer would catch up in three years.
These numbers suggest that in a “normal” environment, an aggressive purchase policy is difficult to rationalize from a wealth
perspective. No buyer should expect 6% appreciation in an environment in which the mortgage rate is 7%, yet 6% appreciation is needed to justify an aggressive policy. On the other hand, no account is taken of the benefits to the aggressive buyer from living in a more expensive house.
Readers can assess their own unique situation using the spreadsheet used to compile these tables. It is on my Web site.
|Income Tax Rate of Buyer 15%|
|3% or Lower||Never||Never||Never||Never||Never|
|5%||12 years||20 Years||Never||Never||Never|
|6%||7 Years||11 Years||25 Years||Never||Never|
|7%||2 Years||3 Years||7 Years||Never||Never|
|8%||1 Month||1 Month||1 Month||1 Month||26 Years|
|9%||1 Month||1 Month||1 Month||1 Month||7 Years|
|Income Tax Rate of Buyer 35%|
|2% or Lower||Never||Never||Never||Never||Never|
|4%||14 years||28 Years||Never||Never||Never|
|5%||7 Years||12 Years||Never||Never||Never|
|6%||1 Year||1 Year||3 Years||Never||Never|
|7%||1 Month||1 Month||1 Month||1 Month||23 Years|
|8%||1 Month||1 Month||1 Month||1 Month||11 Years|
|9%||1 Month||1 Month||1 Month||1 Month||1 Month|
|Note: The aggressive buyer pays a mortgage insurance premium of .53% for 10 years.|
Buying the Next Home Before the Existing One Is Sold: Many homebuyers are dependent on the equity in their existing house to finance the new one, but the closing date on the new one comes first. The cash needed to close before the sale can be obtained through a swing loan from a bank, or a home equity loan on your current house.
If you have a contract of sale on your current house, many banks will make a “swing” or “bridge” loan for the period between the closing on your new house and the closing on your old house. I used a swing loan on my last purchase, and it was relatively simple and hassle free. While the rate may be high, the interest payment won't amount to much if the period is short.
Banks aren't crazy about swing loans because they realize they are one-shot affairs and they are unlikely to see the borrower again. Go to the institution where you currently hold your deposit, whether it s a commercial bank, savings and loan association, or credit union. Let them know that as a customer, you expect this service.
A home equity loan is likely to be more costly than a swing loan, although the cost will be influenced greatly by the amount of equity in the current property and on how astutely the borrower shops. Pay a higher interest rate if necessary to avoid points (an upfront charge expressed as a percent of the loan amount), other upfront fees, and prepayment penalties. On a three-month loan, a borrower can afford to pay an interest rate up to four percentage points higher to avoid paying a fee equal to 1% of the loan.