We just went under contract to buy a house. Yes, in this market with these interest rates, we are buying a house. We can’t put our life on hold because interest rates are higher than they were a year ago. The real world doesn’t work like that. Humans are, as it turns out, not economic zombie bots who make all financial decisions based on optimization.
Our youngest is turning three next month, and she will be ready for a “big girl bed” that doesn’t fit in the nursery. The plan was always to move up to a bigger house, and we think we’ve finally found one that meets our needs. It’s too early for congratulatory remarks though. We still have to get through the inspection period. And in a town like New Orleans, with old houses, nothing is a guarantee. I’ll keep you posted on the progress.
As we negotiated our way to the purchase price, I came face to face with the endowment effect in real life. The endowment effect is a bias that causes us to overvalue something that we own, regardless of the market reality. Simply because we own it, we assign a higher value to it. Daniel Kahneman and Richard Thaler studied and wrote about the endowment effect after conducting a series of tests with students in 1990. After distributing coffee mugs to half of the students, they asked the students to trade the mugs for an agreed-upon price. Despite the theory suggesting that half of the mugs would trade hands, Kahneman and Thaler found that far fewer mugs were exchanged. The students who had randomly been given the mugs, assigned much higher values to the mugs than the students who had not received a mug.
Nowhere is the endowment effect more obvious than in the housing market. Everyone believes their house is worth more than it is, including you. You can admit it. Home prices spiked in the post-Covid era of late 2020 and 2021. Mortgage rates were at all-time lows, and incomes saw the first meaningful increases in over 40 forty years. These forces combined with the underlying demographics of low supply (from the below-trend building since the GFC) and high demand (from a huge number of Millennials reaching peak household formation age). But like some of the stock market prices printed in 2021, those gains in the housing market were short-lived.
And so we come to the house we just took under contract. The sellers put it on the market in May of 2022, for what was probably a hopeful price even at 3% interest rates at the height of the frenzy. There were no offers, so they dropped the price by 7.5% in July and then another 7.5% in September. That’s when we went to an open house to check it out. It seemed to fit all of our needs – 4 bedrooms, a big yard, a nice neighborhood, and room for my husband’s workshop that we’d need to build. But we felt the price was still too high given the market environment, and we were fairly confident there would be no other offers. We decided to keep watching it.
Last week, the sellers dropped the price for a third time and scheduled another open house. We decided that if we were serious, it was time to make an offer. We did, for much lower than their third price drop. I know that must have been painful, and I think they almost rejected us outright. But they countered a little lower than the asking price. After another round of counteroffers, we were so close in price, we decided there was no need to “win” the last round and accepted. Whew! It wasn’t as easy as I expected in a frozen housing market. But, the endowment effect is strong.
IF we close on this house, we will fix ours up to put on the market. I will be interested to see how the endowment effect feels on the other end of a housing transaction. Will I refuse to believe the market, or will I accept the true price of the house? Stay tuned, I will write about it.
Consider how the endowment effect may impact your investment plan. Are you reluctant to let go of stocks because you have pipedreams about their value? Are you missing out on opportunities because you’re not willing to pay the current market price?