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Wednesday, November 15, 2006

The Monthly Payment Buyer

The excellent personal finance blog Get Rich Slowly (highly recommended—one of my daily reads) posted a link yesterday that reminded me of a topic that I've been meaning to post on. As I read the story, titled "Cars affordability: Cheapest since 1980" I couldn't help but think about the stark contrast between the price trends of cars versus real estate. Granted, land does not "wear out" in the way that cars do, so you wouldn't expect real estate today to cost less than in 1980, but there is a similarity in the buying process of each that I've been thinking about lately.

Cars and real estate are similar in that the purchase price is negotiable. Think about the negotiation process that you go through when you buy a car. If you're a smart buyer, you come to the table with a pretty good idea of what the car is worth, and negotiate the price based on that bottom-line. The monthly payment, taxes, fees, dealer extras, and trade-in value are important factors in your total out-of-pocket cost for the car, but they are all secondary to the purchase price of the vehicle. Consider this quote from the Edmunds.com article Confessions of a Car Salesman:

From my commission check it was clear that the minivan couple could have made a better deal and saved several thousand dollars. So where did they go wrong? Well, first of all, they negotiated as monthly payment buyers, rather than bargaining on the purchase price of the vehicle. When you agree to be a "monthly payment buyer" several variables are introduced that are harder to keep track of: the term of the loan can be extended up to 72 months (six years!) without your awareness and the interest rate can be raised. When you bargain on purchase price, it is a cleaner, simpler way of negotiating.
If you think about it, this is exactly what has happened with real estate. The combined forces of super-low interest rates and loose lending practices have turned the vast majority of home buyers into "monthly payment buyers." A recent post by Ardell at RCG titled Beginning the Home Buying Process illustrates this phenomenon (emphasis hers—as usual):
STEP 1: The first step is the most extensive one, as it combines many factors. Home Price, which is determined by monthly payment affordability, cash needed to close, and commission to be paid to the Buyer's Agent.
The first step is to base your home price on your "monthly payment affordability"—exactly the mistake mentioned above by the undercover car salesman that led to overpaying by thousands of dollars on a new car. In my opinion, it's no wonder that home prices have gotten so out of whack with true fundamentals, when the first question someone asks in the home buying process is not "Is this house worth $XXX,000?" but rather "Can I afford $X,000 per month (no matter what kind of financing it takes)?" Obviously a monthly payment must be affordable, but should that really be the sole determining factor in whether a house is worth buying?

The longer this kind of mindset goes on, the more detached the price of real estate becomes from where it "should" be. In a way it pisses me off, because I know that for every person like me that thinks "there's no way that house is worth $500,000!" there are hundreds (probably even thousands) of people that say "if we stretch our budget, we can afford $2,500 per month," and thus the lunacy continues.

At least I know that the madness will end eventually, one way or another.

(Chandler Phillips, Edmunds.com)
(Ardell DellaLoggia, Rain City Real Estate Guide, 09.08.2006)

14 comments:

MisterBubble said...

Whoa...Tim...what did you do to the stylesheet? My eyes are dying!

That said, before someone comes along with the inevitable straw-man argument that home buying is nothing like buying a car (which it isn't), realize that home financing is very much like financing a car purchase -- under-handed (or naive) seller's agents can manipulate your perception of price, so long as they're allowed to play with payment terms at the time of price neogtiation.

The question I've had for quite a while is this: why have lending standards tanked? Why is it even possible for lenders to be making 50-year mortgages to everyone who can fog a mirror? What changed that allowed this financial hindenberg to inflate?

Danny said...

It is absolutely true that many buyers in today's market approach a new home purchase by first determining what they can afford on a monthly basis. Many home sellers try to take advantage of this in their marketing strategies and are able to use it to great success. However, they are very actively aided by the lenders who design and offer new types of loans often to borderline customers. I met with a couple the last week about selling them a home. When I asked about financing they said they had talked with a banker who assured them she could find a loan program to fit their needs; after all she had more than 260 programs available! I think this situation is getting out of hand and I genuinely hate to see naive home buyers talked into taking out loans they cannot reasonably afford. I only hope the results are not as bad as some are now predicting. Otherwise, the housing economy could have a serious impact on our national economic stability in just a few years time.

Danny Ferguson
Oklahoma City Real Estate
Oklahoma Custom Home Builder

Anonymous said...

Why the whinning about lending standards? I do not feel much sympathy for the person smart enough to make enough money to be able to pay $2500 towards his mortgage and at the same time stupid enough to think in terms on monthly cash flow for homes / cars. This probably is same person that carries a credit card debt.

I have a much bigger question than lending standards - till when does borrowed money hold this country afloat? Its like a pyramid scheme. Very interested in what happens down the road and how housing will handle the eventual bursting of the more ominous credit bubble.

Eleua said...

Money will hold the economy together as long as the collateral-at-the-margin is sufficient. Once the ball starts to roll backwards, the game is over - and over in a big way.

This swerves right into a point I made almost a year ago on ClearcutBainbridge. If people are shopping a monthly payment (and they are), if interest rates go up, the amount of house they can afford really tanks. It is breathtaking to see just how much the price of a house goes down, as interest rates rise, with constant payments.

Factor out the "speculative premium" that people put toward "getting on the equity escalator", and take out some more money for inflationary diversions in other areas of the family budget, you have a complete wipeout of just about all equity in the entire nation.

Given how banks will get religion, and not loan money to any stiff that crawls in the doorway, it is game over.

Just think...if banks required 20% down payment (and I'm talking a real down payment, not a piggy-back loan), and we have a universal equity wipe-out, just how much will a nice home cost?

How many 30-somethings do you know that have $40K in liquid assets? How about $20K?

Pretty creepy when you think about it...

Debt is for real, and it sucks.

Nolaguy said...

IMO, the credit bubble will continue to expand until Japan and China stop buying the huge bundles of risky US debt.

The folks selling these bundles of debt are making lots of money - and everyone wants in on the action, so all the banks/mortgage lenders are in a landgrab to find as many debtors as possible. It's low risk to them when China and Japan keep buying the stuff.

And why do China and Japan do this? To make sure Americans have plenty of disposable income to buy their products.

Richard said...

Man, one of my old co-workers is buying a new home now.

He was originally looking at something in the $300K range, but after talking to a loan broker at Countrywide, he discovered he could afford mid $400's due to the "other loans available".

He's 28. Recently married. Not a finance guy...

S Crow said...

RE Loans

Many of these ARM loans are fixed for 10 yrs (I/O) so it reduces exposure to interest rate swings quite a bit. Additionally, 10 yrs out prior to 1st adjustment anniversary allows for a long period in which to potentially gain equity and ride out market swings. If the borrower does not pay down any principal in that period and/or job loss enters the fray, then perhaps it spells trouble. But that could also be said for 30 yr fixed borrowers.

stephen said...

I don't disagree with you often but on this the process is not really the same. With the car situation you are talking about using the monthly payment to price THAT car, thus the terms being tailored in such a way that you pay more for THAT car than you should.

With RE you are using monthly payment to determine the price of the house you can afford. Correct me if I'm wrong but most folks get pre-approved or at least pre-qualified in order to establish what they can afford and then start looking in that range.

To me that makes perfect sense and the way the majority of folks go about buying a house.

That's is why we have a RE/credit bubble because folks could afford more with low rates so buyers could ask more and lenders stepped in with a ton of firewood to stoke the flames.

To close I completely agree that the monthly payment is the reason for the bubble but I don't agree that folks are dumb to use the amount they can afford each month to determine the price of the house they should buy.

plymster said...

...I don't agree that folks are dumb to use the amount they can afford each month to determine the price of the house they should buy. - stephen

The problem is that people are using the maximum amount they can afford per month, and assuming that their variable mortgage and 2nd mortgage (call a HELOC what it is) rates won't increase. This is dumb because people are betting that interest rates won't rise above historic lows, or that they'll get a bump in pay that will cover it, or that they can refinance into a lower monthly payment, or that they can sell. When push comes to shove, none of these are viable options anymore.

Eleua said...

Actually, I am of the opinion that people, especially the marginal buyer, are just that dumb.

Joe and Mary Buyzalot go about purchasing their home in the following manner:

#1 - how much money can we throw at purchasing a house every month?

#2 - what loan package will give us the biggest bang for the buck?

#3 - take the numbers from #1 and #2 and convert to purchase price.

#4 - call Cookie & Candi, the real estate Wondertwins, and say you are in the market for a house in the #3 + 15% range.

#5 - hope nothing bad happens

#6 - hope something good happens

stephen said...

I guess I just don't agree.

It's very easy to simply believe that when people do something contrary to what you would do they must be stupid...

Tens of thousands of folks come to this website monthly digesting what others have to say. Many on this blog enjoy renting, others want to buy a house. Everyone wants a nice place to live. When folks buy houses they can't afford it's largely because of this not stupidity.

Does that mean I think it's right that that corporate greed has milked this human weakness and allowed folks to lie their way into houses they can't afford, no.

Do I feel sorry for young people who haven't done their homework and paid a quarter of a million bucks for a cramped apartment, yes.

But in the end it's seldom stupidity. Wishful thinking, maybe. Greed, some. Mostly it's just biting off more than you can chew.

Me, I'm freaking brilliant, and I will only cool my heels so long in an apartment and then I will pay the going rate and buy a house. I'll get a loan that works for me (that's a fixed one in my case) and I won't spend a lot of time mulling the market after I move in. I won't mind if prices plummet short term (saves me taxes) but not so much I have to worry about the bank calling collateral.

Of course I hope to buy after prices drop but contray to some I don't think there is some SMART time to do so. Now, six months, next year? Time will tell :-)

A house is not an investment, it's your home...

PepeDaniels said...

Stephen said: Does that mean I think it's right that that corporate greed has milked this human weakness and allowed folks to lie their way into houses they can't afford, no.

Do I feel sorry for young people who haven't done their homework and paid a quarter of a million bucks for a cramped apartment, yes.


At the risk of being overly agreeable :-) let me say that there are a number of good points here and not necessarily contradictory.

I think what Stephen is saying is a good point. There's a lot more behind the house buying orgy than is on the surface. I'm not suggesting that people shouldn't wise up but as George Carlin says - "We're only a few steps out of the jungle".

We had a wild drop in the stock market at the end of the nineties in which a number of people lost their shirts and retirement funds. This was followed by 9-11 and an administration that went out of it's way to scare the crap out of people. Its patriotic call? Go shop. I think there are a lot of people who would say that the Fed's were handing out the equivalent of financial Ben & Jerry ice cream with rates where they were.....I think American's are pretty brainwashed on some level about home ownership and cars. So, I'm not excusing it really just saying that I think there's more to how people have gotten into the mess.

Let's face it, not everyone has functioning BS detectors.

eleua said:
How many 30-somethings do you know that have $40K in liquid assets? How about $20K?


I think this is another side of the story that isn't always calculated in. I know far too many people who own who are struggling with credit card problems. It's not just the high mortgage payments or the lack of a real downpayment but the lifestyle that goes with that McMansion. It's the need to drive (at higher gas prices) out to Home Despot for all the power tool goodies and home projects you're going to do and on and on. You're not going to drive a piece of crap to work every day right? And that home theatre system looks pretty good and is marked down %10 this week.....

I think people are spending wild money really and don't even stop to see what's going on at a basic level.....I don't mean it in a condescending way, but I live a bit out of the mainstream in my values and it looks like a mess in a lot of cases when I think of the monthly outlay for people.

Also,a lot of twenty and thirty somethings are wildly in debt for college loans as well. Part of the conditioning for becoming adult home owners I suppose? On some level it's the American way isn't it?

Just some random thoughts really....

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Smell a Good Deal for a Real Estate – Try to discover a property that has already got some equity in it, when you purchase it. Equity represents the value of a real estate, a property after you have paid any mortgage or other charges relating to it.

Try to Get a Second Mortgage on the Real Estate – You could try to be more creative and ask the seller whether he would be willing to have a second mortgage on that home. Thus you could set up an agreement with the seller through which you will have to pay monthly an approximate sum of $200, for instance, on $15,000 of the price of the real estate (plus or including the interest rate), for the second mortgage.

Save Some Money to Pay in Advance – Some lenders might give you a full credit if you come with at least a small percentage of the sum. This would grant you supplementary points for getting the credit and would also lower the interest rate – e key point of any mortgage refinance program.

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Danny said...

It is interesting to come back to some of these comments six months after the fact when we are starting to see some of the impacts of the previous mortgage market. Things are definitely beggining to look shaky for some of those loans made with adjustable rates, 0 down, and all of the other gimmicks the mortgage companies were using to push their products. It will be very interesting to see how things fully unfold over the next year or so.

Danny
Oklahoma Health Insurance