Buy low, sell high . . . and lose

We all know the drill, don’t we, that the key to success with financial investments is to “buy low and sell high”? So, since the majority of the predictions floating around right now are that real estate prices are going to continue to drop for another 12 to 18 months, we should wait that long before we buy any real estate. Makes perfect sense, doesn’t it?

Well, not necessarily, and especially with real estate.

The important thing to keep in mind here is that there is the difference between “price” and “cost.” For an investment like real estate, which is usually leveraged with a mortgage, you need to be more concerned with the cost than the price. This is such an important concept that lenders are required to disclose the total cost to the buyer – as accurately as possible – and give the buyer the opportunity to back out of the deal. If it turns out that the estimated cost was not accurate enough, lenders are now required to recalculate it and disclose it again.

So what is the difference between price and cost? Simply put, the price of the house is only part of the cost. Over and above the price, you have to pay for a lot of other stuff. In real estate, most of the “other stuff” is interest on the loan that was taken out to pay for the house. There are other pieces and parts included in “cost,” but the interest on the loan is the most important part.

The thing about interest is that little changes in the rate can have dramatic effects on the true cost of the house. Let’s imagine you’re buying a new home, and the 30-year loan will be for $350,000. If the interest rate is 4.5%, the principal and interest payment will be $1,773.40. If the interest rate increases only half a percentage point to 5%, the payment will be $1,878.88. An increase of only half a percentage point will cost you over $100 every month for the next 30 years.

Now here’s the thing: interest rates are rising now.

As of today, average 30-year mortgage rates are over two-tenths of a point higher than they were last week. In other words, if you closed that $350,000 loan today at the average rate (4.83%), your payments would be $1,842.68, or $46.33 higher than if you closed at last week’s rate (4.61%, with a payment of $1,796.35).

But what about the falling price of the house? Won’t it offset the increase in interest? Only if the decrease in value is substantial. To expand on that last example, the price of the home would have to fall to about $341,200 to offset that rate increase of half a point. In other words, the price would have to fall more than 2.5% in the same week to come out even with the increase in the interest rate.

Real estate values are not falling that fast, and are not expected to in the coming months. Most predictions I’ve seen are in the range of 5 – 10 % spread over the next 12 months or so, but the falling prices are not nearly as important as the rising interest rates.

If you are in the market for a new home, it is time to make a decision. Choose wisely.

The essence of strategy is choosing what not to do. -- Michael Porter