Buying a property is perhaps one’s most significant expense in life. For most people owning a home is one of the most important goals.
Others, on the other hand, view property investment – as a way of generating wealth through buying with the possibility of selling at a higher price in the future or earning monthly payments through renting.
Throughout the years, low-interest rates on bank deposits encouraged people to seek alternative ways to generate income on their dormant money. They considered buying other properties as one of the safest and easiest investments.
The transaction involves the buyer giving the seller money for a property. The parties involved are a notary and an architect to safeguard the buyer’s interest.
Prospective property buyers might not have all the money required to purchase a property. Therefore they turned to banks to provide the money to finance the purchase. The banks obliged.
As the demand for property increased, their prices increased too. The price increases got transferred onto the buyers, causing banks to issue higher mortgages for comparable properties that were cheaper in the previous years.
Even though property prices increased significantly, people kept buying and buying, and banks kept lending more money.
The belief is property is one of the safest investments. Nonetheless, there are three significant assumptions to this theory.
The first assumption – Everyone pays their loan
Who wouldn’t pay their loan? The bank will take your property if you don’t pay your loan. One must distinguish between not paying a loan and being unable. The first implies a choice, while the second doesn’t.
Inflation is a general increase in the prices of goods and services, and one of the tools that central banks use is to increase interest rates to control it. The idea is to remove as much money from the economy by encouraging people to spend and borrow less. If they save more, they’ll deposit the money they have in their bank. People who don’t have money will need to borrow. If interest rates increase, it will be more expensive for them to borrow, and this discourages them from lending. Therefore it will decrease the money available for spending.
Unlike property, salaries and wages tend to remain fixed over a long time or increase at a slow rate.
Inflation affects the prices of goods and services, and interest rates affect loan payments.
If interest rates go up, the value for money of consumers goes down. Higher inflation and interest rates mean you’ll have less money to spend on wants and luxuries, as your needs and loan would have already taken a bigger bite from your salary.
Consumers’ spending is the businesses’ revenue, so less disposable income means lower business revenues and profits. Big profits become smaller profits which eventually become losses.
Businesses always try to keep their revenue as high above their expenditure as possible. If revenue goes down, expenses need to go down, too, leading to layoffs.
Layoffs lead to unemployment. If people don’t earn any income, they can’t spend money, forcing people to be unable to pay their loans.
Second assumption – Banks will keep lending money
The primary purpose of any investment is to buy it cheap and sell it at a higher price. The more significant the difference between the buying and the selling price, the higher the profits.
If sellers know that buyers are buying their properties at any price, they’ll keep increasing their prices as they know they’ll sell them at a higher price.
Central banks try to control inflation by increasing interest rates. The higher the inflation, the higher the interest rates; this means that the interest rate on loans will increase, and one will have to pay higher monthly loan payments.
Given the low-interest rates on loans during the past few years and the high prices of properties, banks are already lending money to people at the maximum they can borrow.
Banks usually decide whether one’s eligible for a loan by looking at the salary. Banks assume your monthly loan payments shouldn’t exceed 30% of your salary, give or take. If you earn $1,000 every month, your monthly loan instalment shouldn’t be higher than $300, leaving you with a disposable income of $700.
Banks will lend you more money if you have a higher salary, as you’ll have more disposable income. If you earn $5,000 every, your monthly loan instalment could be around 50% of your salary. Half goes to the loan payment, and the other half would remain in your pocket.
In the latter, the monthly loan instalment is 50% of a salary of $5,000. While in the first scenario, it was 30% of the disposable income, i.e., 50% is $2,500, while that of the 30% is $700.
In the table below, let’s assume someone will borrow $200,000 for 25 years with a salary of $3,000 per month.
|Capital||Interest rate||Monthly payment||Monthly payment as a percentage of monthly salary||Total payments over the lifetime of the loan||Total interest over the lifetime of the loan|
- A few months ago – The 3% interest rate was the cost of borrowing up to a few months ago, in late 2021. The monthly instalment is around $1,000, or 32% of a $3,000 salary. Total payments over the lifetime of the loan would be around $285,000.
- Now – The interest rates on loans after the Federal Reserve increases now float around 6%. The monthly instalment on the same loan is now $1,290, or 43% of a $3,000 salary. Total payments over the loan’s lifetime would be around $386,000—an increase over the 3% interest rate.
- Soon – The 9% interest rate is the most likely that we’ll have at the end of 2022. If the rate increases from 6 to 9%, the monthly instalment is $1,678 or 56% of a $3,000 salary. The total payments over the loan’s lifetime would be around $500,000. Two and a half times higher than the original sum you borrowed.
If the bank lent someone money when interest rates were low, there’s nothing a bank can do except pray that borrower pays back the loan.
However, the bank will unlikely lend money to someone new when the interest rates are high on the same salary when interest rates are low. If the bank lends money, it will increase the risks that the borrower will default. Banks are risk averse and most likely won’t loan the money.
Third assumption – Increases in the prices of properties are sustainable
When investing, one must always assume that there’s always someone willing to buy your investment at a higher price than you bought it, or else you’ll end up selling it at a loss.
Tieing it to the second assumption, if banks don’t give prospective buyers a loan, buyers wouldn’t be in a position to buy a property.
There will come a time when buyers won’t afford a home because banks won’t give them the money to do so. On the other hand, sellers can’t sell their property at the buyer’s price because they’ll sell it at a loss.
For example, a bank is willing to lend someone money to buy a property that costs $200,000. The seller is willing to sell its property to the buyer at $250,000, as the property costs the seller $225,000.
If the seller manages to sell the property at $250,000, the seller would have made $25,000 in profit. To break even, the seller can only sell it for $225,00. Here the seller is not making a profit nor a loss. Anything below $225,000 is a loss for the seller.
Even though the seller may be inclined to sell at $225,000, the buyer can only pay $200,000. The $25,000 between the buying and the cost price will create a gap in the market, as supply doesn’t meet demand.
Who will give in first?
The buyer can’t increase his offer because his bank restrains him. On the other hand, the seller has wages to pay and loans too. Sellers wouldn’t want to get caught up with many properties they can’t sell.
The buyer will shop around for a better deal from other sellers, flipping the property market from a seller’s market to a buyer’s one.
The seller may sell the property at a loss or with little or no profits.
How will this play out in the end?
The prices of properties have increased significantly over the past few years, maybe too much that basic properties have become unaffordable, causing buyers to get priced out of the market.
Persistent inflation will increase interest rates, making it harder for borrowers to buy as disposable income shrinks and people spend less. Less demand means fewer sales for businesses creating unemployment.
Microsoft, Facebook, Google and other multinationals have already signalled recruitment freezes and redundancies. So far, things seem to be going down that path.
However, everything is fluid, and everything may change. No one knows, however, we can predict with a certain degree of doubt.
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