Economic Principles Applied to Buying a House

Introduction

Buying a home is one of the single most important economic decisions that most people make. Because it is such a significant decision, it is important to examine all the relevant considerations carefully. This essay discusses principles of economics as they apply to making decisions about purchasing a home. It reviews the decision-making process and how it is affected by marginal benefits and marginal costs. The health of the economy and international trade are also factors to consider, along with conditions that could have led to a different decision.

Supply and Demand in the Housing Market

One principle that affected the home-buying decision was the law of supply and demand. The number of homes available for sale is influenced by both sides of this relationship. On the supply side, how many homes are for sale is driven by selling prices. If people see that they can sell their homes for higher prices, more of them are willing to sell, all other things being equal. The converse is also true: more people are discouraged from selling when prices are low.

The unemployment rate also affects the supply of homes. The more people there are out of work, the more people fall behind on their mortgages and cannot afford to keep their homes. These properties add to the overall supply either through voluntary short sales or through involuntary foreclosures. As of January 2012, the total existing-home inventory in the U.S. amounted to a 6.1-month supply at the current sales rate (RealEstateABC.com, 2012). This figure does not take into account what analysts call the shadow inventory — distressed properties being kept off the market. Experts believed that shadow inventory would continue to keep prices low for years to come (Tarbox, 2012). Knowing that home prices would not increase significantly in the near term meant there was no urgency to buy immediately in order to secure the best price.

On the demand side, a large number of prospective buyers would drive up prices — a situation known as a sellers' market, which is a normal part of the economic cycle. In the market conditions of early 2012, however, demand for homes was below normal. Some buyers were waiting for prices to fall further, some could not qualify for bank loans, and others were concerned about job security and did not want to take on a mortgage only to risk being laid off. All of these factors combined to keep housing demand lower than usual.

Interest rates also affect supply and demand. When interest rates drop, the cost of obtaining a mortgage falls, which creates more demand and pushes prices upward. The opposite is equally true (Nguyen, 2011). Beyond the short-term effect on housing supply and demand, higher interest rates increase marginal costs and opportunity costs for buyers. Government intervention kept interest rates low during much of the recession, but rising rates in recent months had made home-buying somewhat less affordable.

When all these factors are considered together, supply exceeded demand in many housing markets across the U.S. at that time. This imbalance kept prices depressed and affected the broader economy as well. A report by a Raymond James investment analyst described weak GDP growth for the first quarter of 2012 and concluded that the housing industry, consumer spending, and the economy in general remained depressed (Brown, 2012).

Trade-offs and Opportunity Costs

Another important principle that shaped the home-buying decision was the concept of trade-offs. Even in a weak economy, available homes at any given price point are limited in supply. Choosing from homes within a particular price range involves trade-offs. For example, buying a home in the suburbs where prices are lower requires a longer commute to work — a significant trade-off given rising gasoline prices. Alternatively, one location might be preferred over another because of school district quality, lower crime rates, or a faster rate of property appreciation. Weighing all these options meant deciding how to allocate income to secure as many desirable features as possible.

The single biggest factor in the decision was income. Only a certain portion of monthly income could reasonably be committed to a mortgage payment. Every dollar spent on the house is a dollar that cannot be spent on transportation, vacations, furniture, savings, or other priorities. These opportunity costs are ever-present when buying a home, and the magnitude of those trade-offs nearly argued against purchasing at all.

Thinking at the margin also affected the decision. The deliberation included whether to afford an extra bedroom or bathroom, a larger garage or yard, or a new home versus an older one. The process of shopping itself caused incremental shifts in priorities and spending plans.