Why aren't people buying houses? Real vs Nominal Interest Rates

People wonder, with interest rates at 2.5%, why aren't people buying mortgages? 2.5% is a great rate! People bought lots of houses at much higher rates during the bubble, right?

The people who wonder that are confusing nominal interest rates with the real cost of a home mortgage. Back in reality, buying a house with a mortgage (or cash, for that matter) is much more expensive than it looks.

Let's do some bubble math with round numbers to make it easy. Say you are buying a house for $100K with a mortgage you are going to pay 5%/year (APR) to the bank on.

So in the first year, you pay $5K for your mortgage, right?

Wait, there's more... in the bubble, what someone was willing to pay you for the house you bought with that mortgage may have gone up another 10%, that "inflation" of the price effectively paying you $10K for having made the purchase.

So now after a year, you've been paid $5K and the bank got $5K on the deal. Everybody wins and you were stupid if you didn't take out a mortgage and buy some real estate. Sound familiar?

They literally were paying you to buy something with a mortgage. Your effective cost wasn't 5%, it was negative 5%. You were getting paid to buy something you couldn't afford to pay cash for with a mortgage. If you had cash, you got paid 10%, but that's not our story today.

Obviously, I'm ignoring the long term to focus on one year at a time, but the story is true if the same conditions of inflating prices continues. Most people only live somewhere for 5-10 years, so it doesn't have to continue as long as you think.

So back to the present. What's the current cost of buying real estate with a mortgage? The nominal rate is down to 2.5%, but what's the real cost?

Same $100K house/mortgage example. 2.5% (APR), you pay the bank $2.5K in interest. Now, however, your house will depreciate and be worth less than you paid for it in a year. To say how much less depends on the real market where you're at and such, but as an example, let's say 7.5% less.

So someone will only pay $92.5K for your mortgaged real estate and after a year you are out $2.5K and $7.5K for a total of $10K. So now your real first year cost for buying that house with a mortgage is $10K, or more like 10%.

So with the change from rising house prices to dropping house prices, instead of getting paid to buy a house with a mortgage, it's now cheaper to rent than pay 10% a year for the privilege of buying a house. The 2.5% you pay the bank is dwarfed by the 7.5% your house is deflating.

How do we get out of this mess and turn the arrow back to rising housing prices? Finish foreclosing on everything that needs to be and sell it all at the current market value as fast as possible. That clears the market and while it's a quick drop, afterwards the cheap foreclosure houses are off the market and it starts making sense for people to buy again, since the arrow is going up again. Every government program to delay foreclosures and keep people owning underwater houses they can't afford just drags the process out longer and longer and means we have a slow decline in prices instead of a quick one. And with a slow decline in prices instead of a post-crash slow increase, nothing turns around because no one can afford the real interest rate of losing money on their home and mortgage.

2.5% is only cheap for a mortgage if prices are steady or slowly increasing. Most people haven't thought it through to the logic behind what's happening, but market prices still tell them what they need to know. Not a good time to buy just yet.

Hat tip to Scott Sumner for continuously pointing out that nominal interest rates don't matter, it's real interest rates that matter instead.