What is the impact of the $10k new home buyer credit?

Recently the governator announced that he will sign AB 183 into law. I mentioned to my co-worker that this will create a micro-bubble and raise the price of house by $10k for the duration of the tax credit (may1-dec31 2010)

Today, he comments to me that actually the bubble might be more than $10k higher price. Let’s make the simplifying assumption that instead of a tax credit spread through 3 years, the tax credit is actually a cash payment that the government gives you at the point of closing. And also, let us assume, without serious loss of generality, that the home buying reward is given to all home buyers instead of new home buyers.

Then, he’s argument is, if you put down the $10k that government gives you into the downpayment, you actually save more thank $10k. Because you won’t have to pay the interest of those $10k. So the total  savings will be

10000*(1.05)^30 = 43129.42

(assuming 5% mortgage interest), so a dumb person may be persuaded to buy a house as high as $43129.42 above it’s actual market price if there wasn’t an incentive.

Now, let’s take this a step further. Say the interest rate is zero, and the lowest amount of down payment a person can pay in order to buy a house is 10%, then this $10k incentive allows him to buy a house that is $100k more expensive than the market price without incentive. So gives us a bubble of $100k above normal.

The psychology of this is well known. A person would probably be satisfied with keeping $5k of the incentive and allow seller to take the other $5k, but he would probably not buy the house if he was only able to keep $1k and the buyer takes $9k.

Anyways, the true size of the bubble will be known soon enough…

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