Every few months, someone wants to know if its a good time to buy real estate. A reader asked an interesting question:

Interest rates are artificially low and we won’t see rates this low for a long, long time. What are your thoughts on buying vs renting for a first timer? In my gut I know that housing is still overvalued, but should I jump on low rates and lock in a fixed payment knowing that future inflation will make this payment even smaller?

Most people do not pay cash for their homes, they get a mortgage. And the monthly payment they can afford, along with the current interest rate determines how large a mortgage they can qualify for.

Lets do some back-of-the-envelope calculations. If you can qualify for $2,000 a month (lets  ignore principle, taxes and insurance for now) and rates are 5%, you’ll qualify for approximately $480,000 worth of mortgage. If rates rise to 6%, you only qualify for $400,000 worth of mortgage.

Did you see how a 20% rise in interest rates caused a 17% decline in the amount of mortgage you would able to qualify for?

If your income isn’t going to increase 20% over the next 2 years, but rates might rise 20%, less people will be able to afford homes. So the pool of available buyers for our $480,000 house has become a lot smaller and demand drops off. According to economic principles, as the demand decreases, prices should decrease as well. Thus, the price should drop to $400,000 to match the purchasing power of buyers.

Additionally,  the banks have unsold inventory sitting on their books – in many cases they haven’t even foreclosed on people who stopped making their payments a year ago.

So we have a scenario where the number of homes on the market is likely to increase or stay flat, interest rates are going to increase, and incomes aren’t going anywhere.

The only reasons you should be buying a house right now are

1. You’re starting a family, don’t want the hassle of moving and can afford a reasonably large house which you will live in for several years
2. You can afford to pay cash and don’t care where the market is going
3. You have specialized knowledge of the markets and can get a much better deal than your local home buyer. Real estate investors will be able to take advantage of the current environment to buy cheap homes that generate positive cashflow.
4. You have a stable job, expect to be in the same place for several years and don’t want your landlord telling you that you can’t paint the living room bright pink

In short, don’t be mesmerized by the tales of real estate agents and Realtors telling you that interest rates will go up and price you out of the market. Only a booming economy with people falling over themselves to buy houses can do that. It may seem like people are out buying homes, but its a temporary phenomena created by all the government to stimulate the housing market. When this stimulus ends, homes prices will probably drift down by the same amount. On a similar note, ZeroHedge has a good article on how dropping homes prices are inversely correlated with rental rates, something I have not been able to verify with my properties!

Only buy a house if you have a good reason to buy one. Don’t get suckered in to it.

At some point we will see inflation, but it’s next to impossible to figure out when.