originally posted February 9th, 2015 by Rod Sager
So many buyers get wrapped up in the notion of securing the lowest price on a house. This is part of the natural buying process. We all want a great deal right? The funny thing is that we are generally selective with that desperately seeking deals mentality. Houses, gasoline, electronics, and cars are items that Americans will shop to death until they find the golden deal. Other things like groceries, clothing, and shoes not so much. I see people buying Campbell's soup at whole foods. $2 for the same exact product Winco sells for 99 cents. Whole Foods offers many top grade products that are not available at discount markets, like Winco. So Whole Foods has its place. Funny thing that is. Oddly purchase price on items we pay cash for is paramount. It is the only thing that matters so long as the product is the same. Houses have many variables. The largest of these is interest rate. I think it is very important to recognize what the difference is between even subtle rate changes.
Two scenarios interesting results:
200,000 home 30 years fixed FHA at 4.5% with 3.5% down.
- Down payment is $7,000
- PITI payment is $1,371
- Total of payments over 5 years is $82,260
- Total interest paid over 5 years is $41,609
- Balance on loan after 5 years is $175,935
210,000 home 30 years fixed FHA at 4.0% with 3.5% down.
- Down payment is $7,350
- PITI payment is $1,368
- Total of payments after 5 years is $82,080
- Total interest paid after 5 years is $38,960
- Balance on loan after 5 years is $183,291
Using a fixed annual appreciation of 4% (actually lower than we are seeing now) we can calculate a future value for both houses. The first house would be valued at $243,331 and have an equity position of $67,396. The second would be valued at $255,497 with an equity position of $72,206. The lower interest rate on the loan allows for a more rapid pay down in principle and places the buyer in a stronger position to sell later. We always want the best price but not at the expense of a higher rate of interest. Right now rates remain very low, lower even than I used in these scenarios. Buyers may miss a golden opportunity if they wait to long to buy. Many buyers continue the effort to barter down prices in a seller's market. With each house they fail to buy due either to being out bid or flat out rejected by the seller, they run the risk of an interest rate hike. Even if they get the "deal" they are seeking, in the long run they may very well still end up paying more and they probably "settled" on a less than prime home.
Let's look at two more scenarios with a larger down and long term implications added:
$200,000 home 30 years fixed at 5.0% with 20% down
- Down payment is $40,000
- Amount borrowed is $160,000
- PITI payment is $1,116
- Total of payments after 30 years is $309,209
- Total interest paid after 30 years is $149,209
- Total of payments after 5 years is $66,960
- Total interest paid after 5 years is $38,461
- Balance on loan after 5 years is $146,925
$210,000 home 30 years fixed at 4.5% with 20% down
- Down payment is $42,000
- Amount borrowed is $168,000
- PITI payment is $1,108
- Total of payments after 30 years is $306,443
- Total interest paid after 30 years is $138,443
- Total of payments after 5 years is $66,480
- Total interest paid after 5 years is $36,219
- Balance on loan after 5 years is $153,145
Here I used twenty percent down so the difference is less dramatic. The striking fact here is the house that cost $10,000 more has a slightly lower payment since the interest rate is a half point lower. The fact is the half point better rate buys 5% more house. Too many buyers hold out for the best price only to find that rates go up or that prices go up and the deal they are seeking never materializes. Notice how much less interest is paid in the first five years on the more expensive house. The buyer of the $200,000 home will pay $2,200 MORE in interest over the first five years with the higher rate.
Let's assume again the real estate market appreciates at an annual rate of 4% over the first five years in each of these transactions. This time lets handicap the more expensive house by suggesting it was slightly over price and the "cheaper" house was slightly under priced. Let's say the target value of the scenario one house is is $202,500. Scenario one represented a $2,500 "deal" and scenario two was $2,500 above market so its base value is $207,500. In general the market doesn't allow for much fluctuation. And buying a fixer and fixing it up versus buying a move in ready home is an unfair comparison. After five years the market value of the houses is $246,372 and $252,455. All else being equal, scenario one (less expensive house) has $99,447 in equity and scenario two has $99,310. The more expensive house did have a higher down payment of $2000 and a higher loan amount by $8,000 and yet after five years the equity position is about the same. If the scenarios were not handicapped the equity position in the less expensive house would be $96,405 versus $102,353. In my experience they are rarely any "deals" in real estate. There are too many buyers competing for the same houses. Some buyers find "deals" by looking at houses that need a little TLC. They don't show as well and thus don't generate as high an offer. Once the TLC is done the buyer reaps the benefit of the now higher value.
The moral of the story is that the lower price is nowhere near as important as most buyers think and interest rates determine how much house you can buy or more importantly how quickly you reduce principle on your loan balance.