Home Ownership Costs: Opportunity Costs
Four Major Variables that Determine Market Price
Over the last four days we looked at the four main variables that determine home price:
- borrower income,
- allowable debt-to-income ratios,
- interest rates, and
- down payment requirements.
Today we are looking at tax implications and opportunity costs because these number will give you a more accurate measure of the impact home ownership will have on the owner’s financial life.
When a buyer puts money into real estate and takes ownership, it changes their financial life. Money for a down payment had to come out of some other asset even if this is only a savings account or CDs. The place where the money used to be parked either paid interest or provided some return. The interest, dividends or positive change in value of the competing asset is an opportunity cost the buyer must consider.
For instance, a buyer could choose to rent and park their money in a 2-year CD and earn about 2.25%. When someone goes to buy a house, they will take money out of CDs and put it into real estate where it earns nothing — unless prices appreciate. However, when considering the purchase from a cashflow basis, owning the asset can provide a cash return if your cost ownership is less than the cost of renting the same unit. This return is independent of appreciation and provides the only reasonable financial reason to own when prices are flat or declining.
Calculating Opportunity Cost
Projecting future costs is more an art than a science. Trying to estimate the opportunity costs of an average investor over the life of a 30-year mortgage is a guess at best. However, since this opportunity cost is real, there are useful theoretical models for providing an estimate to use in decision making.
Interest rates on savings are tethered to mortgage interest rates as all debt and deposit instruments are tied together in the web of risk and return in the debt market. The loosely correlated relationship between mortgage debt and reliable savings returns like medium-term Certificates of Deposit is the basis for estimating opportunity cost.
When mortgage interest rates are very high, the demand for money is high, and lenders will be paying high CD rates to try to supply the demand for money through loans. The inverse is also true. When lenders do not need money to loan, interest rates fall, and lenders do not need to pay borrowers much for money. Plus, in a deflationary environment the lender has no reliable customers to loan the money to anyway.
This direct relationship between mortgage interest rates and CD rates — irrespective of how loosely correlated they may be — is the basis of my calculation. I assume as mortgage rates go up, CD rates will go up 66% as fast.
When I put in different test numbers, the stretching spreads this formula creates does re-create the same phenomenon that happens in the real world when inflation expectation is added into the market’s thinking.
We have the ability to override our default settings and put in whatever inputs you believe most accurately reflects your financial situation in our reports.