Today, we will look at two families, the Peakers and the Troughers (gotta love those names, right?) Both families have a combined family income of \$150,000 per year, and they have both saved \$100,000 they can put toward a downpayment on a house.

It is the Summer of 2006, and each family is looking at a \$1,000,000 home. The Peakers think the property is a good deal, so they put their \$100,000 down and borrow \$900,000 with an adjustable-rate mortgage starting at 6% with a 10-year fixed period followed by a 20 year fully amortized payment at a new interest rate. Their monthly payments are \$4,500 a month, but after all of the adjustments for taxes and fees and the other costs of ownership, their total monthly cost of ownership is \$6,000 per month.

The Troughers, on the other hand, made the same calculation and decided that the cost was simply too high. They decided to rent and wait for prices to drop to rental parity. As it turns out, this \$1,000,000 home can be rented for \$3,000 per month (the cost of ownership was double the cost of rental in the summer of 2006.) In order to make this comparison apples-to-apples, the Troughers have decided that will live the same lifestyle as the Peakers, so they will put \$3,000 per month into their downpayment fund while prices are dropping.

Fast forward to 2011: five years later, rents have been increasing at about 4% per year, so the Troughers are now paying \$3,500 per month in rent, houses similar to the Peakers are now selling at rental parity which is about \$560,000. During this five-year period, the Peakers and the Troughers have enjoyed exactly the same lifestyle: both have had use of a house with similar characteristics, and both have been living on the same amount of disposable income. The Peakers are now \$340,000 underwater 5 years into their 10-year fixed term, and they are stressed about what will happen. The Troughers have a mountain of cash, and they are about to buy a home.

The Troughers have accumulated \$325,000 in their downpayment fund by adding the rent savings each month and having this compound at 5% interest (the calculations are too cumbersome to post.) The Troughers now buy the comparable house for \$560,000 using all of their \$325,000 downpayment. This only leaves a \$235,000 first mortgage. These Troughers are thrifty people, and in keeping with our all-things-being-equal example, the Troughers are going to continue to put away the same \$6,000 a month the house is costing the Peakers. They will put \$4,543 toward their mortgage, and the remainder toward other ownership costs. By making this \$4,543 monthly payment — something they were used to doing from their 5 years of renting and saving — they will pay off the mortgage completely in 5 years.

Fast forward to 2016: It is now 10 years since the Peakers have purchased, and they still owe \$900,000 on the house. Let’s assume they got very lucky, and we quickly inflated another housing bubble that brought the resale value of their home up to \$1,000,000 — breakeven. The Peakers are facing a dramatically escalating payment as the 900,000 is about to convert to a fully-amortizing loan over the remaining 20 year term. Their payment will now rise to \$6,447. Let’s hope they are making more money to pay for it.

Here we are in 2016, both families have enjoyed the same amount of spending money each month and the same lifestyle (remember the tax benefits are already figured in to the cost of ownership.) The Peakers have a \$1,000,000 house on which they owe \$900,000. They will either need to make a \$6,447 payment or refinance again. The Troughers also own a \$1,000,000 house, but their mortgage is completely paid off. Their only cost of ownership is reduced to taxes, insurance and maintenance. Whereas the Peakers are trying to figure out how they are going to make payments, the Troughers suddenly have \$4,500 a month extra in their monthly budget, and their net worth is \$900,000 higher than the Peakers.

What happens if we do not inflate another bubble, and comparable houses are only worth \$800,000? What if interest rates go up to 8% or higher? The Troughers couldn’t care less, they are saving money versus renting, and they have plenty of equity; however, the Peakers are in trouble, and they may lose their home. People who bought at the peak are betting on appreciation, and they are betting against higher interest rates. Not a good bet to make when interest rates are near historic lows and prices relative to fundamental valuations are at unprecedented highs.

You can spin this example any number of ways, no matter how the Troughers save or spend their money, they will come out far, far ahead of the Peakers. They could either enjoy a better lifestyle (no mortgage equity withdrawal for the Peakers,) or save for retirement, or save for their larger downpayment. In the real world, those who did not buy at the peak can balance those options to best suit their needs and wants, the Peakers do not have these options. They are imprisoned in their house. Let’s hope it is a gilded cage.

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