One is better off buying an undervalued asset with a higher interest rate vs. buying an overvalued asset with a low interest rate. Reason being: first the obvious, better opportunity for appreciation over time with an undervalued asset. Second, you will have a better opportunity to refinance going forward as rates may become more attractive. Taxes: you will have a higher tax deduction on a higher interest loan and you will also be paying lower property taxes on the lower purchase price. Locked in: you will most likely not be locked in your home for a very long time because you would ideally be gaining equity vs. losing equity to market depreciation. Bottom line, now is not a good time to be buying real estate.
Response to question about the effect of interest rate increases on affordability.
In the early stages of mortgage rate increases Housing affordability will certainly get worse. In fact, affordability may worsen right up until the time that rates flatten or start down.
Consider upside potential from a buyer’s standpoint. Would you rather have a $1500 payment at 9% or at 5% assuming each is for the same house? I would certainly prefer the 9% loan. Since the payment is the same, I would owe less money. I would have the possibility of large home price increases as interest rates decline. The 9% rate also gives me a great investment opportunity for making addition principal pay down. Paying additional principal is essentially a safe investment at 9% compounded!
I would also have the option of refinancing later to lower my payment or increase principal pay down.
On the other hand, there is very little upside from the 5.5% loan. There is very little chance for substantial rate drops. If you are buying in that environment, you are probably paying a very high purchase price for the property purchased.
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