Should you purchase first home whilst asset price inflation?

July 19th, 2007

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Recently, we received an email from one of our readers,

Having read many of your topics on the housing market it seems that it would be a bad idea to invest in housing at the moment – given the slow deflation of the housing bubble, coupled with cheap credit inflating prices to an unstable level, it would seem likely that any investment in this area carries a fairly high level of risk.

But I’m curious to your thoughts on those first home buyers (such as myself) that aren’t looking so much to invest as a business, but are simply looking to start a home.

The way I see it, the options of my partner and I are limited.  We can continue renting, and risk having to pay even more for a house in a few years if prices continue to raise – or we can look at purchasing a house now, at an artificially inflated price, and risk having the bubble burst on us.

The context of this email is on the many articles that we had written on the Australian housing market.

As we all know, there are talks about the un-affordability of housing in the Australian media and this has become a political issue in an election. The sky-rocketing property prices over the past several years is part of the global crack-up boom in asset prices (see Epic, unprecedented inflation).

As to whether investing in Australian residential property is ?risky? or not, we cannot say much in the general sense except that when the inevitable deflationary crunch comes for global asset prices, residential property prices are likely to tag along as part of the overall downward forces on prices (see Spectre of deflation).

On the other hand, if we decide to remain invested in this period of cracked-up boom of asset prices, Australian residential property is one of the last places for us to put our money in because there are better places to do so.

 Now, what about those who are planning to buy their first home?

The risks faced by first home buyers are different from investors because there is no return on investments to consider. However, the risks they face are of a different nature. In fact, there is only one root risk to the first home buyers?the ability to service the mortgage. We will look at the various factors that may affect this risk:

  1. Interest rate rise? As we said before in Have we escaped from the dangers of inflation?, at this rate the supply of money and credit is expanding globally (including Australia), it is inevitable that price inflation will rear its ugly head sooner or later. We recommend that you read our earlier article, Cause of inflation: Shanghai bubble case study to learn more about the root cause of price inflation. Therefore, for people with mortgage, it is prudent to arrange their finances with the assumption that interest rates are going to be in an upward trend for at least in the medium term. Having said that, it is still possible for interest rates to be cut? when the economy is hit by a threat of recession or depression, which is possible Black Swan. This brings us to the next point.
  2. Unemployment? Let’s say there is a recession (or depression). Unemployment will surely rise, depending on the severity of the economic slowdown. It is very likely that asset prices will fall in such economic condition. Unemployment will result in loss of income, which will mean the inability to service the mortgage debt. Worse still, in times of asset price deflation, when the property is foreclosed and goes into a fire sale in a depressed market, the borrower can end up in a situation called negative equity. This is the situation whereby even after the property is forcibly disposed of in a sale, the delinquent borrower is still faced with debt because the sale price is far below the originally borrowed amount.

Can the economic boom still continue? Remember, Australia’s economic boom had been going on for more than 16 years, which is by far the longest stretch of boom (see Another sign of the business cycle top). Our belief is that now is the time to be more careful with our finances (i.e. fatten ourselves financially for the inevitable economic winter).