Inflation and interest rates seem to be the buzzwords on everyone's tongue today. These words sound scary and the general consensus is that, while we know what rising interest rates and inflation are, most people are not at all certain how these things that we keep hearing about will affect your buying power and your bottom line.
Inflation is an average increase in the prices of a collection of goods and services in a given economy over a set period of time. In layman's terms, this means that what you can buy for your dollar is decreasing, so that huge chunk of money that you have scrimped and saved and sweated and sacrificed to save for your down payment and closing costs is decreasing in value and what you can buy with it, and as inflation continues to rise you can buy less and less.
Interest rates or, more specifically, mortgage interest rates have in the last 5 months gone from hovering around 3% for years to increasing up to over 6%.
To best illustrate how this impacts your average borrower let's tell the story of the Smith family. They were approved for a One-Million Dollar Home Purchase with 20% down at a 3% interest rate for a well-qualified buyer. In February-April of 2022 as interest rates started to rise Mr. Smith decided to put the brakes on the home purchase and “wait until rates come back down.”
Fast forward to today. Did you know that interest rates just hit above 6% for the first time in 14 years?
Our friends The Smiths having decided that interest rates are not coming back down anytime soon are looking at their purchase again. They contacted their lender and at their new 6% interest rate with the exact same income and credit and debt to income ratio are now qualified to purchase a seven hundred thousand dollar home. Yes folks, you read that right, their buying power has decreased by 30%.
Now you might all be saying, "Well yes, Lucas, but that means that home sellers will immediately discount their asking prices to make up for the difference right?" Not likely. The average homeowner (me, and you included) love their home and they usually have an overinflated sense of the value of their home.
This is normal and it's called 'pride of ownership,' so despite rising interest rates and out-of-control inflation most homeowners choosing to list their home on the market now will fall into the classic trap of only looking at historical sales data to determine their starting market price, and using this data based on sales made with radically different economic factors is a mistake that they will pay dearly for.
They will pay both in time cost by spending days with their home languishing on the market getting few showings and no offers. Also, they will lose actual hard dollars by not receiving good solid pricing advice and being able to get their home on the market and get it sold, therefore having to keep lowering their price and trying to chase the market down in order to get their home sold.
Eventually, these sellers who chase the market end up getting a lower price than if they had simply received good advice in regards to pricing and put their home on the market at a price that would cause it to sell.
So while these factors will eventually affect home prices, home buyers will not see this as an immediate drop but rather a gradual decline. A very gradual decline and with a record-low inventory level still probably not as sharp of a decline as your average home buyer would like to see. My prediction is we will see an overall 15%-20% drop in home prices over the next two years.
You might be thinking, "Well Lucas, thanks for all the good info but maybe I’ll just 'wait and see,'" and I am going to say that if you are in the Smiths position, buy that 700K home and move in! Why? Because even when these economic factors start to affect that home's value, the fact is that since 1970 home values have continued to appreciate and will continue to do so.
And while interest rates will continue to rise and fall, when they do, the Smiths will have the opportunity to refinance the home that they now own at a lower interest rate. In the meantime, not only will they have enjoyed the benefits of homeownership such as stability and accruing equity, but they will also have invested in their future on a monthly basis by paying their own mortgage rather than their landlords.