Tuesday, April 2, 2013
Money Is a Lot Like Water
Money is a lot like water. It is always moving. Consider your house, at the same time your largest investment and your largest expense. The value of your home, as well as the price you are paying to remain in it are constantly changing. Local events like the construction of a new factory might increase its value. If the only factory in town closes, its value might drop to nothing. Real Estate professionals remind us that there are three components to evaluating a house location, location, and location. There is some truth in that saying, but there are also global forces that affect the magnitude and period of the waves of valuation. In an article entitled Your House is An Undiversified Bond Investment, the anonymous author observes that like a bond, the valuation of a home moves with the prevailing interest rates. As the rates go up, the value of the house tends to goes down. As the rates drop the value of the house tends to go up. When you buy a home, in essence you have issued a bond to the holder of the mortgage. For access to the money necessary to purchase a new asset, you have promised to make good on the principal and the interest over the term of the bond, typically 30 years. Why 30 years? I would guess that in the past, 30 years was the expected working life of a typical employee. This means the house should be paid off just about the time he or she retires. Just as there is a market for sovereign debt (Government Bonds) and corporate debt, there is a market for mortgage debt. In the distant past your mortgage tended to stay in the hands of the bank that gave you the money to buy your home. Somewhere along the line that changed. Back in 1987 I took out a mortgage from a Savings and Loan in Florida. After a few years that mortgage was sold to a bank in Oklahoma. It stayed in Oklahoma until I paid it off. More recently banks had the bright idea of packaging mortgages into secondary bonds. Much like certain chicken products safe mortgages and subprime mortgages were ground up, bleached, mixed with some chemical preservatives and sold as white meat. It was a disaster. When the word about what was in those products became general knowledge it very nearly caused a meltdown of the world financial markets. In addition to local and global forces, the individual buyer should be limited by common sense. There are some rules of thumb that can be stretched, but stretched too far they will come crashing down on the unfortunate family who tried to build their home without carefully counting the cost. Ultimately there seem to be some limits to just how much house a family can afford. The traditional rules of thumb are you can afford a house that costs 3 times your gross annual salary. Another traditional rule of thumb is your monthly mortgage payment should never exceed 35% of your monthly take home pay. Families who violated these rules during the housing bubble are still paying the price. They are stuck with their heads underwater in homes that are worth less than the price at which they can be sold. The author of the article tracks the value and price of a hypothetical home in his market, San Francisco. It was built in 1991 and sold for $450,000. After the buyer put down 20% the payments on a 30 year fixed mortgage worked out to $3,428. Then the market went wild. Home prices rose with rising incomes and declining interest rates. The owners were able to refinance at lower rates while the equity in their home took off like a rocket sled on rails. At the peak in 2007, that home sold for $1,300,000! Then reality set in. There were just not enough buyers who could afford such a property to justify the price. The marketplace decided that at those prices they weren’t going to invest any more money in mortgages. The money flowed off in other directions. Some of it, as we know, just vaporized. The author notes that after over 20 years that house is right back where it started. With a 20% down payment the mortgage payment is $3,600 a month. Yes, the price of the house has doubled in 20 years but financing costs have declined by about 70%. Like the waves in the ocean, driven by tides, wind, currents, and even the efforts of the Army Corp of Engineers the levels of water and money rise and fall, but tend, over time, to return to predictable levels. Now let’s be careful out there.