This paper examines the financial advisability of purchasing a home during a period of economic uncertainty, drawing on core economic principles to guide the analysis. It explores how supply and demand dynamics affect home prices and interest rates, and introduces the time-value of money as a framework for evaluating mortgage costs against alternative investments. The paper also addresses opportunity cost, tax deductibility of mortgage interest, and the concepts of marginal cost and marginal benefit as tools for individual decision-making. Ultimately, the paper argues that low home prices and low interest rates make purchasing a home a rational choice for financially stable buyers, while acknowledging that the decision depends heavily on individual circumstances.
The paper demonstrates applied economic analysis — the technique of taking formal microeconomic and macroeconomic concepts (supply and demand, marginal cost/benefit, time-value of money) and systematically applying them to a real-world consumer decision. Rather than simply arguing a position, the writer builds a multi-variable framework that readers can use to evaluate their own situations, which gives the argument both rigor and practical utility.
The paper follows a four-part structure: a scene-setting introduction that contextualizes the post-financial-crisis housing market; an "Economic Principles" section covering foundational concepts (supply/demand, time-value of money, opportunity cost, amortization, and tax considerations); a "Macroeconomic Effects" section that elevates the analysis to marginal cost/benefit reasoning with illustrative examples; and a brief conclusion that synthesizes the findings into a conditional recommendation for financially stable buyers.
Recent and ongoing events in the national and global economy have caused a major reevaluation of priorities and possibilities for large corporations, government entities, and individual consumers in terms of their financial security and futures. Many firms and investments that seemed to be unshakeable foundations and unstoppable earners have simply and suddenly disappeared, and a vast amount of the world's wealth has vanished along with them. The value of many commodities has also dropped significantly as consumer spending slowed, and the general pullback of the economy led to rising unemployment rates in much of the world that were only beginning to show signs of settling after more than two years of climbing. In short, the economy has been behaving in ways that no one really expected, and this has caused a great deal of continuing uncertainty.
Few areas of the U.S. economy experienced more volatility than the housing market. The real estate boom — or "bubble" — has been cited by many analysts as a major source of the economic downturn as a whole, with inflated home prices driven by questionable mortgage lending practices and vice versa. When homebuyers began defaulting on mortgages they could never really afford, banks began failing and home prices began to plummet as it became clear that few consumers could afford to buy, and few lending institutions had the funds to help them.
This is, of course, a highly oversimplified account of what occurred in the housing market, but it is enough to give one pause when considering a home purchase. Though home ownership has long been seen as a — if not the — major step toward financial independence and security, the reality of this view is definitely questionable in the current climate. In the pages that follow, a variety of considerations directly relevant to the decision of whether or not to purchase a home will be examined in order to determine the financial advisability of moving ahead with a purchase at this time. Ultimately, this decision depends on an individual's specific financial situation and must include certain non-financial considerations, but by looking at the various costs and benefits of home ownership a more rational and realistic assessment can be made, even in this period of ongoing volatility and uncertainty.
There are several basic economic principles that must be considered when evaluating the purchase of a home. The simple rules of supply and demand have a direct effect on both the affordability and advisability of a home purchase, influencing not only the actual price of real estate but also the availability and cost of the capital necessary to make such a purchase (Fish, 2011). Other issues such as opportunity cost, compound interest, and amortization must also be taken into account; so while some of these concepts may appear simple on the surface, their interactions are in actuality quite complex.
Supply and demand has a direct impact on home prices. When there is high demand for homes — that is, many buyers — with lower supply levels, prices rise. Fortunately, the reverse is also true: in many areas of the country, prices have dropped considerably because fewer people can afford to purchase a home in this economy, meaning lower demand. For those in stable and financially comfortable situations, this means buying a house right now is a fairly good idea, all else being equal, as lower home prices represent greater value and potential return (FinPipe, N.D.). Interest rates are also affected by supply and demand, through one of the most basic financial concepts: the time-value of money (Fish, 2011). Simply put, the time-value of money asserts that a dollar today is not worth the same as a dollar at some other point in time (Fish, 2011). This principle relates to many other financial concepts that are highly relevant when considering a home purchase.
Most homebuyers cannot afford to pay cash for a home, and instead must borrow most of the purchase price from a lending institution. Essentially, the buyer is using future dollars before they have been earned — they see greater value in having access to those dollars now — and they pay the bank interest for this privilege. Meanwhile, the bank's funds come from savers who see more value in having their dollars later, and they allow the bank to lend those dollars in exchange for earning interest (Fish, 2011). When there are many savers and few borrowers, demand for present-day dollars is low, and interest rates drop — borrowing becomes a less costly privilege (Fish, 2011). This is precisely the situation that currently exists.
The combination of low home prices and very low interest rates makes this an attractive time to purchase a home compared to other periods. This does not mean the decision should be made on these features alone, however. The time-value of money must also be considered from another angle: opportunity cost. Money spent on a home mortgage is money that cannot be spent elsewhere, so the cost of owning a home must be compared with the alternatives in order to determine whether it makes true financial sense (FinPipe, N.D.; Secor, 2010). In other words, just because buying a house is cheaper right now than it has been for some time and than it is likely to be for another long period, not everyone should necessarily rush to purchase a home. It is often cheaper to rent the type of home one wants to live in than to buy, and this must be taken into account (Secor, 2010).
The issue of opportunity cost cannot be adequately addressed without a specific situation and concrete figures at hand. Money spent on a mortgage does build up some form of value, though the home's appreciation might not be fast enough to recoup the money lost to interest over the life of the loan (FinPipe, N.D.; MI, 2009). Furthermore, the down payment required to purchase a home could be invested in a number of different financial growth vehicles — CDs, bonds, stocks, and so on — and could be earning interest at a faster rate than the home appreciates (FinPipe, N.D.). In such a scenario, purchasing a home would be the less reasonable financial decision, depending on the earning potential of alternative investments compared to home appreciation.
To complicate matters further, the interest paid on a home loan is generally tax deductible, while interest earned from investments can be taxed; this adds an additional layer of savings to home ownership and an additional cost to using that same money for wealth-building investments instead (MI, 2009; FinPipe, N.D.). The decision of whether or not to purchase a home must therefore be based on a rational and comprehensive calculation of all relevant factors: specific interest rates on the home loan, projected earnings on investments, comparable rental prices, expected increases in home value (which are especially difficult to predict in the current market), and the length of time one expects to own the home. Using one's last savings to purchase a home with mortgage payments that prevent any further saving is probably a bad idea, while a purchase that still allows for long-term cash investments and savings is more attractive, assuming comparable home values and expected appreciation levels (Secor, 2010).
The term "opportunity cost" is often used in a highly qualitative way — buying a house means forgoing the ability to invest that capital; renting means forgoing the ability to build equity in real property. A related concept is marginal cost, which reflects essentially the same trade-off but in a quantifiable form. Marginal cost can be compared to marginal benefit, which is a numerical representation of what something is worth to the consumer. A high marginal benefit is generally associated with a low marginal cost, and vice versa.
In the current economy, the marginal benefit of owning a home is highly questionable from a strictly financial viewpoint. There is no guarantee that home prices will rise considerably in the near future, and even long-term prospects for home price increases might not beat inflation (FinPipe, N.D.). The same can be said of alternative investment areas, however. Although the stock market has seen a major rebound in recent years, continued gains are by no means assured — in fact, stocks were virtually flat over the previous decade despite the enormous boom in housing prices. This means that marginal costs and marginal benefits cannot be determined in a far-reaching, objective, and purely financial sense, but must instead be evaluated from the perspective of the individual consumer (Secor, 2010).
MI. (2009). What is amortization? Retrieved February 18, 2011, from http://www.moneyinstructor.com/doc/amortization.asp
Secor, S. (2010). Should I buy or continue renting? Retrieved February 18, 2011, from
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