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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)

8 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.

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

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