An Opportunity Cost Primer

There has been some optimistic chatter of late. With the Federal Reserve's recent rate hike, it's expected that interest rates on savings accounts are quick to follow.

And thus suggested: You'll have an easier time saving for that down payment now that you have safe, FDIC-insured, compound interest to help you out. This idea played out on Wednesday's Marketplace with Nela Richardson and Felix Salmon. Some disagreement from Salmon followed over the weekend's Slate Money podcast.

It's not safe for me to assume that your most important short-term savings goal is a down payment for a home. I will simply refer to to some great thoughts on homeownership from Joshua Sheetz (Radical Personal Finance). Further, the much praised New York Times Rent vs. Buy calculator.

My question for you: In what situations will an increase in short-term interest rates help down payment savers?

The Down Payment

This country has an extremely bad habit. We tend to generalize or nationalize the Real Estate Market. Thus, we lump down payment savers into the exact same group, regardless of the local market they occupy.

In reality, markets vary widely. All real estate is local: a truism that experienced real estate investors are quick to repeat. In my recent School District & Housing Shuffle article, median home prices for 3 bedroom houses (in the top 100 school districts) range from $79,550.00 to $1,864,000.00. Typical (20%) down payments will also vary thusly:

$15,910.00 vs. $372,800.00.

The variance between home prices is unbelievable. There is no single 'national' home market.
How will better savings interest rates affect either market? It turns out that price is not the only issue with savings interest rates. We will have to factor in price inflation.

Price Inflation: An increase in the price of a standardized good/service or a basket of goods/services over a specific period of time (usually one year). Because the nominal amount of money available in an economy tends to grow larger every year relative to the supply of goods available for purchase, this overall demand pull tends to cause some degree of price inflation (Investopedia).

Opportunity Cost

The cost of an alternative that must be forgone in order to pursue a certain action. Put another way, the benefits you could have received by taking an alternative action (Investopedia).

Wait & save vs. buy now is our question today. Let's try a simple scenario with a completely flat housing market (0% price inflation) and a 1% interest rate:

In this base (and unrealistic) scenario, there is no loss of opportunity over time. Buyers in this market have no incentive to jump into the market this year over next. Thus, the low savings interest rate provides some impact for these savers.

Real markets do have price inflation and deflation. The old rule of thumb in real estate is your most generic market appreciates roughly 2-3% / year. Here's a scenario for a very generic market, Tulsa, Oklahoma (Zillow Data):

Tulsa is very affordable. A buyer saving $5000 / year will eventually hit the goal. In the mean time, the price inflation is working against their savings rate. The effect is even more brutal in a runaway market, take Seattle for instance (Zillow Data):

*9.65% is that average of 2015 growth (12.7%!) and expected 2016 growth (6.6%).

A Seattle buyer saving $20,000 / year will not hit their goal in 5 years. Furthermore, the net impact of price inflation vs. savings will overwhelm their return on savings.

I do recognize it's naive to assume that Seattle price inflation will continue at 9.65% for 5 years. Most agree it's better to make projections on a conservative scenario, than one that is overly optimistic about affordability. Had this article been directed at home sellers, it would have been growth conservative from the other side of the spectrum (assume low growth when selling, high-growth when saving).

There is, however, one type of market where waiting on the sideline provides even more opportunity. A market with expected price deflation. Just to give a dramatic example, here's Detroit (Zillow Data):

A Detroit buyer saving $2000 / year gets the compounded effect of interest rates and price deflation. They can hit the goal in year four, with a net gain in opportunity.

And my point is?

When it comes to real estate markets the statement "Increased savings interest rates will help down payment savers," while true, is not quite the whole story.

If you're dead set on buying, the best thing you can do is cut lifestyle costs and up the yearly savings. If you are having trouble getting to 20%, it's a good sign you are in a market that's overpriced for you, and you should be wary of holding the debt in the first place. You can use any of the widgets to run your own numbers. Get expectations for your market via Zillow Home Values.

This analysis is very simplistic. There are varied reasons why anyone would want to live in one place over another. There are varied reasons why people buy or rent homes.

Hopefully you have read this as mere encouragement to factor in opportunity cost and expected market inflation. There is great danger when individuals stretch their resources to purchase a home that is a bad fit. Even more danger when it's a home they cannot afford. Know your numbers, know your longterm savings goal.

Timeline Neutrality

Rent when it's appropriate, and buy when the market makes a temporary correction. The smartest real estate investors made all their purchases in 2009-10.

If you are not tied to an exact timeline, you can buy and hold higher yield products and do much better than a bank savings account. Preferred shares, some high yield bonds, REITs, and Treasury Bonds (all ETFs or funds) come to mind. These products are not FDIC insured, but they can make you a more reputable 3-6% in yield while you figure out your plan.

There are conservative ways to invest like a retiree. Do your best to preserve the principle, but make some money while you're at it. This approach requires great discipline. You have to ride the emotional roller coaster a little more than with a bank account. Check out my article on Anniversary Funds for some ideas.

Most importantly, do the things that serve the needs of your family and community. Avoid the pitfalls of consumerism. Use and enjoy your money wisely. Happy Holidays!

More Resources:

A look at opportunity cost in the housing market. Use our widget to calculate your savings path to or away from a down payment.