It's a big purchase, so why not invest some time in basic financial analysis
Ben S. Bernanke refinanced; how about you?
The Federal Reserve chairman, who bought a rowhouse on Capitol Hill in 2004 using an adjustable-rate mortgage, saw his payments surge in 2009. He refinanced late last year into a 30-year fixed-rate mortgage, for "a little over 5 percent," as he told Time magazine.
It's a reminder that even the leading thinkers in economics and economic policy have to make the same kinds of routine decisions about buying and financing a house that the rest of us do. And there is a lot that all of us can learn from economic analysis in a search for a place to call home.
The decision to buy a house is an inherently risky decision. A house is an illiquid investment, time-consuming and expensive to sell. It's expensive, usually several times the buyer's annual income. It relies on leverage (borrowed money) and is significantly affected by tax policy through the mortgage interest deduction.
Although it may not be practical to pick up an advanced degree just to decide whether to make an offer on a three-bedroom bungalow, there are some relatively simple concepts about economics, economic policy and finance that should factor into your thinking about home buying. I cover the U.S. economy and the Federal Reserve for The Washington Post, and here are some analytical tools I relied upon while weighing my purchase of a Logan Circle condominium in 2008. None of these can determine whether buying is the right decision for you -- but each can make you a more informed shopper.
Inflation is your friend
When prices rise across the economy, it is commonly thought of as a bad thing. But for a new home buyer with a mortgage, it can be a boon, particularly if that mortgage has a fixed interest rate.
In the long run, home prices rise only a bit faster than inflation; the steep price rises of the late 1990s and first half of the past decade were an aberration, not the norm. This means that the rate of inflation plays a major role in determining the value of your home when you go to sell, even as the amount you owe on the mortgage is fixed. And the return is magnified by the use of leverage, or borrowed money, which also magnifies your loss if the value of the home declines.
For example, for a family that buys a $400,000 house with $100,000 down and a 5 percent, 30-year fixed-rate mortgage for the remaining $300,000. Let's assume that the home's value rises one percentage point above the inflation rate each year, which is about the long-term historical average.
If the family sells the house 10 years from now, it still owes about $260,000 on the mortgage, regardless of how high inflation has been. But if annual inflation was 5 percent during that span, the house's resale value has risen so much that the family's profit, after paying off the mortgage, would be $273,000, compared with $205,000 in profit if inflation had been 1 percent. (Both values are stated in current-year dollars, adjusting for inflation).
Lesson: If you expect inflation to be high in the coming years, buying a house is a more attractive proposition.
That's bad news, actually. Economists are now expecting many years of very low inflation. And some analysts worry that inflation could fall even further, perhaps into negative territory -- a dangerous, self-reinforcing cycle called deflation. That would be a very bad situation for homeowners, making debt more onerous and putting downward pressure on the value of the homes.
Alternate lesson: If you believe that large budget deficits and easy-money policies from the Federal Reserve will lead to astronomical inflation, then buying the biggest house you can afford becomes a financial no-brainer. Just keep in mind that this scenario is not what most mainstream forecasters -- or the bond investors who have money on the line -- expect.