Personal Finance & Money Stack Exchange is a question and answer site for people who want to be financially literate. It only takes a minute to sign up.
Sign up to join this community
I'm looking to buy a property. I do not want to take a risk on this property. Its sole purpose is to provide me with a place to live. How would I go about hedging against increasing interest rates, to counter the increasing mortgage costs?
Ideally I'd like to not lose money on my property, seeing as I will be borrowing 95% of the property's value. So, I'd like to hedge against interest rates and falling property prices in order to have a risk neutral position on my property.
To avoid risk from rising interest rates, get a fixed rate mortgage. For the life of the mortgage your principal and interest payments will remain the same. Keep in mind that the taxes and insurance portion of your monthly payment may still go up.
Because you own the property, the costs to maintain the property are your responsibility. If you rented this would be the responsibility of the owner of the property; if the cost to repair and maintain goes up so does the rent. Because you are the owner your annual costs to repair and maintain may go up over time.
The way to eliminate risk of loss of value is to never move, until the mortgage is paid off. You will know exactly what principal and interest will cost you over the life of the loan. When you sell that will be essentially return on your payments.
You don't know if the loss of value is due to world, national, regional, local or individual circumstances. so hedging is tough.
If the fact that the mortgage is 95% is what makes you nervous, your biggest risk is risk of being upside down. That risk is greatly reduced by increasing the amount of the down payment. That decreases the risk that the value will be below the mortgage amount if due to unforeseen circumstances you have to sell immediately. The money will still be lost due to decrease in value, but you aren't forced to bring cash to the settlement table if you need to sell.
How can one offset exposure created by real-estate purchase? provides a similar discussion. Even if such a product were available in the precise increments you need, the pricing would make it a loser for you. "There's no free lunch" in this case, and the cost to insure against the downside would be disproportional to the true risk. Say you bought a $100K home. At today's valuations, the downside over a given year might be, say, 20%. It might cost you $5000 to 'insure' against that $20K risk.
Let me offer an example - The SPY (S&P ETF) is now at $177. A $160 (Dec '14) put costs $7.50. So, if you fear a crash, you can pay 4%, but only get a return if the market falls by over 14%. If it falls 'just' 10%, you lose your premium.
With only 5% down, you will get a far better risk-adjusted return by paying down the mortgage to <78% LTV, and requesting PMI, if any, be removed. Even if no PMI, in 5 years, you'll have 20% more equity than otherwise. Over the long term, 5 year's housing inflation would be ~ 15% or so. This process would help insure you are not underwater in that time. Not guarantee, but help.
Note: I am making a USA-assumption here; keep in mind this answer doesn't necessarily apply to all countries (or even states in the USA). You asked two questions:
I'm looking to buy a property. I do not want to take a risk on this property. Its sole purpose is to provide me with a place to live. How would I go about hedging against increasing interest rates, to counter the increasing mortgage costs?
To counter increasing interest rates, obtaining a fixed interest rate on a mortgage is the answer, if that's available. As far as costs for a mortgage, that depends, as mortgages are tied to the value of the property/home. If you want a place to live, a piece of property, and want to hedge against possible rising interest rates, a fixed mortgage would work for these goals.
Ideally I'd like to not lose money on my property, seeing as I will be borrowing 95% of the property's value. So, I'd like to hedge against interest rates and falling property prices in order to have a risk neutral position on my property.
Now we have a different issue. For instance, if someone had opened a fixed mortgage on a home for $500,000, and the housing value plummeted 50% (or more), the person may still have a fixed interest rate protecting the person from higher rates, but that doesn't protect the property value. In addition to that, if the person needed to move for a job, that person would face a difficult choice: move and sell at a loss, or move and rent and face some complications.
Renting is generally a good idea for people who (1) have not determined if they'll be in an area for more than 5-10 years, (2) want the flexibility to move if their living costs rises (which may be an issue if they lose wages), (3) don't want to pay property taxes (varies by state), homeowner's insurance, or maintenance costs, (4) enjoy regular negotiation (something which renters can do before re-signing a lease or looking for a new place to live). Again, other conditions can apply to people who favor renting, such as someone might enjoy living in one room out of a house rather than a full apartment or a person who likes a "change of scenes" and moves from one apartment to another for a fresh perspective, but these are smaller exceptions.
But with renting, you have nothing to re-sell and no financial asset so far as a property is concerned (thus why some real estate agents refer to it as "throwing away money" which isn't necessarily true, but one should be aware that the money they invest in renting doesn't go into an asset that can be re-sold).
It is pretty simple to avoid risk in home ownership:
Do those things and your risk of home ownership is about nil.
You can hedge your house price from losing value if you believe that the housing market is correlated with major stock indices. Speak with a commodities broker because they will be able to help you buy puts on stock indices which if correlated with housing prices will offer somewhat of a hedge. Example. House prices drop 30% because of weak economy, stocks will generally drop around that same amount 30%. If you have enough exposure to in the puts compared to your house value you will be protected. You can also buy calls in 30 year bonds for interest rate lock if you are not on a fixed interest rate. Many investors like warren buffet and carl icahn have been protecting them selves from a potential market downward turn. Speak to a local commodity broker to get some detailed advice, not etrade or any discount brokers they won't be able to help you specialize your trades. look for a full time commodity broker house.
