What don’t buyers invest in when they make a down payment?
Money spent on a down payment could have been invested in other assets that earn a return.
When people buy a family home, they invest in real estate. And since it’s assumed the highly-leveraged asset will appreciate in value at double-digit rates for eternity, and since the bulk of the capital gains are untaxed, nobody considers any alternative to investing down payment money other than to obtain the largest, most-desirable house in the nicest neighborhood they can find. If it weren’t for the housing bust, everyone would still be thinking this way — and despite the bust, some still do!
Any family that’s saved money for a down payment on a house needs to consider what alternatives they could have invested in rather than tying that money up in real estate. Down payment money has a cost; it earns nothing in a house if the resale value does not increase, and this investment could have earned a return if invested in something else. The cost of what could have been earned in an alternative investment is what economists call Opportunity Cost.
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 1.5%. 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.
Personal opportunity costs
While I use the more conservative formula for calculating down payment opportunity costs described above, individuals may have higher opportunity costs. Many business owners remain renters because they chose to invest what they had available in their businesses rather than a house. Their opportunity cost was much higher than the fraction of a percent of a mortgage rate. If investing in one’s own business yields a 20%+ return, buying a home doesn’t pencil out.
Back when the housing market was bottoming in 2011 and 2012, I had to chose whether to buy more cashflow properties or try to buy a home. Since cashflow properties were yielding 15%+ at the time, it made much more sense to spread whatever down payment funds I had available over several small rentals rather than one OC property. It’s a decision I don’t regret.