Unconventional
Wisdom: It’s a Friggin’ Fact – Buy
Assets (including a home) When Interest Rates are High
Like most of my best lessons as a teacher, this blog entry
is inspired by a great conversation with my Economics students in the last few
weeks. One student, in response to my
assertion that successful investments are more likely when interest rates are
high than when interest rates are low, asked “Mr. Lane, is that your opinion or
a fact?” “It’s a friggin’ fact,” I
replied. After reflecting further on the
student’s question, I decided to create an economic model theory to help
illustrate my assertion to the class. In
mathematics, such mental exercises are called ‘proofs,’ and the longer that I
teach Social Studies, the more convinced I am that we are all better off when
we develop similar deductive theoretical proofs.
To prove my theory to the students, I asked them to accept
the following premises:
( (1) there
are a fixed number homes for sale at any one time, and that every home is for
sale at a price of $1,000,000
( (2) there
are a fixed number of buyers for the available homes for sale, and every buyer
has $5,000 per month (or $60,000 per year) in income available for a mortgage
payment
( (3) there
is one single mortgage interest rate available to home buyers: 5%
Under these conditions, every buyer can “afford” to purchase
one of the available homes because Year 1 interest would be $50,000 and the
additional $10,000 of payments could be applied to modest principal
repayment. Therefore, sellers would not
be deterred from buying, and all buyers would be able to achieve their asking
price of $1,000,000.
However, I then asked students to consider what would happen
if some of those premises change a s follows:
(1) as
in the above scenario, there are a fixed number homes for sale at any one time,
and that every home is for sale at a price of $1,000,000
(2) as
in the above scenario, there are a fixed number of buyers for the available
homes for sale, and every buyer has $5,000 per month (or $60,000 per year) in
income available for a mortgage payment
(3) there
is one single mortgage interest rate available to home buyers: 10%
Under these conditions, no buyers can “afford” to purchase
one of the available homes because Year 1 interest would be $100,000, well
above $60,000 that each buyer has to put toward annual mortgage payments. Therefore, sellers would be completely
deterred from buying, and all buyers would be required to lower their asking
price of $1,000,000; the result is downward
pressure on the price of homes.
The simple example above proves that assuming “all other
things equal,” home prices are lower when interest rates are higher. Perhaps more importantly, the interest-rate
relationship to asset prices is a truism such that “all-other-things-equal”
assets can be acquired more cheaply when interest rates are high than when
interest rates are low. Therefore, by
behaving in a fiscally-disciplined manner and waiting for prevailing interest
rates that are substantially above long-term averages, one can buy assets that
are quite likely to appreciate in value as prevailing interest rates regress
toward long-term averages. Therefore,
the absolute truth is that the best time to buy an income-producing entity (a
home, a rental property, or a business) is when prevailing interest rates are
higher than long-term average rates.
