Mark the day. I’m officially bullish on the housing market. I believe that we have hit bottom on both interest rates (within a few bps) and residential real estate prices. Of course there are pockets all over the country where prices haven’t completely bottomed out yet (e.g. south Florida). And there are various statistics that still point the other way. But the reality is when the numbers officially point to the turnaround, then the turnaround already happened. I think that time is now. And hey, if Cision wants to name me the fourth most influential personal finance expert in the nation, then I might as well use my influence. Right?
Don’t stop reading and call your REALTOR. Read this whole post, digest it, and then evaluate how, or if, it affects you. And if you skip the bottom part of this post that discusses who should buy and who shouldn’t, then you will get what you deserve. That’s not a good thing. Your diligence in trying to understand what I’m saying is crucial.
The two measures that support my assertions are interest rates and housing prices. Let’s take a close look at both.
- Interest rates- Mortgage rates remain at historic lows. It has never been less expensive to borrow money to buy a home. According to the chart below (courtesy of mortgagenewsdaily.com), rates have fallen consistently since 1980. My best guess is that mortgage prices will stay very low for the next 12-18 months. To me, this means that 30 year fixed rate mortgages will stay well below 5%. Rates are currently in the mid 3% range. The lower the rates, the lower your payment will be. Or the lower the rates, the more home you can afford. You decide which route you would like to take. Just stick to my 25% rule. Keep reading. Look at the rates over the past 40 years (below).
- Housing prices- The housing market crash is now a good thing…if you are wanting to buy a home. Inflation-adjusted housing prices have returned to normal levels. They were absurd from 2002-2007. Those housing prices were driven by banks lending money to people that never should have been able to borrow money. This drove demand, thus prices increased. It was basic high school economics. But now lending has tightened, foreclosures have driven prices down, and the realistic capitalist in me knows that this is a good thing. I hated seeing people lose their homes. But I don’t hate seeing people get denied loans that they shouldn’t get. It’s not a matter of sympathy. It’s a matter of economics. If everyone starts getting loans again, despite the fact that they shouldn’t, then we will repeat the housing market crash. The big banks have a small amount of culpability in the housing crash, but I believe that the majority of blame lies with the consumer. That is unless you believe that McDonalds is liable for obese America.
Why mortgage rates matter
Let’s examine a current interest rate (3.75%) and a “normal” interest rate (6.0%). Below you will find the first 24 payments of a 30 year fixed rate mortgage for each rate. The comparison is meant so show the relative affordability of today’s mortgage rates.
The first 24 payments at 3.75% 30 year fixed rate mortgage
The payment of $926.23 is acceptable if your net income is $3,704.92 or more per month (based on Pete the Planner’s Ideal Budget). That translates into a gross annual household income of about $60,000. Thus a family with a $60,000 household income can afford a $200,000 mortgage because the mortgage payment based on a 3.75% rate ($926.23) is 25% of their household income. The 25% allocation towards housing is the foundation of being able to truly afford home ownership. But it’s not the only factor. More on that later.
The first 24 payments at 6.0% 30 year fixed rate mortgage
The payment of $1,199.10 is acceptable if your net income is $4,796.40 or more per month. That translates into a gross annual household income of about $75,000. Thus a family with a $75,000 household income can only afford a $200,000 mortgage if interest rates were at 6.0%
Additionally, getting a mortgage at 3.75% versus getting a mortgage at 6.00% will save you $98,233.15 over the life of the loan. That’s nothing to scoff at either.
Depressed housing prices
Sounds depressing, right? Wrong. Depressed housing prices means that homes are more affordable than they have been in the last several years. In fact, sales prices have depreciated 25.2% over the last 5 years in Indianapolis, IN (for example). Homes aren’t only for sale, but they are now ON SALE. You can use the historically low mortgage rates to buy more home…if you so choose.
Of course there’s a big but
Are you excited? If so, things are about to get real. All the above information is great, but we are neglecting one major factor. Should YOU buy a home?
There are two groups of people: people who should buy a home, and people who shouldn’t. This isn’t measured once and judged forever. These two groups are constantly reassessed. It’s quite possible, likely, and encouraged that someone who is in the “shouldn’t own” camp on February 1st, 2012, could find himself in the “should own” on February 1st, 2013. If you can’t afford a home now (by my measure, not the banks), don’t get angry. Just get going. Put yourself in a position to be in the “should buy a home” group.
There are three main factors to consider when assessing your ability to afford a home. We dealt with the foundation factor earlier (mortgage payment at 25% of your net household income). But there are two other factors.
- Mortgage payment no more than 25% of your net income- While you can get approved for more, I suggest that you try to keep your allocation to 25%. In fact, just buy less house. Don’t push the limits. If you “underhouse” yourself, then your life can be much more fun.
- Down payment of 10%- Yes, I realize that you need 20% equity to prevent Private Mortgage Insurance (PMI). But there are other ways around that. My 10% requirement is based on the fact that if you can’t afford to scrap together a 10% down payment, then how are you going to afford the expenses of a homeowner? How are you going to be able to replace that furnace? How are you going to be able to keep your yard looking nice? How are you going to be able to afford an increase in property taxes? If you can’t put 10% down, then don’t buy a home this time around.
- Stay in the home at least 5 years– You expose yourself to great risk when you move into a house on the premise of moving again within five years. Not only was this a popular strategy during the real estate boom of the 2000s, but it had a name: starter home. “Oh, we’ll just move into this house for a couple of years until we can afford more house.” Wha wha what?!?!?! Your goal should never be to constantly afford more. A grounded person’s goal is to constantly need less. Be a homeowner to own the home…long term.
There has never been a worse time to get an Adjustable Rate Mortgage (ARM). If rates are at historic lows, then that means that they are most likely going to rise. ARMs adjust every 3, 5, or 7 years. This means that your mortgage rate, if adjustable, will rise just when mortgage rates find their “normal level.” You don’t want to be in the middle of this normalization. Get your 30 yr or 15 yr fixed rate mortgage now, and leave the ARMs for people that can’t read historical rate charts.
Be smart. Don’t grow into your payment. I said that the housing market is coming back, not employment. Many a young person has put him/herself in a terrible spot by projecting desired income and using that information to make a housing decision. If you have the 10% down payment, then just follow the 25% of household income rule, and you can’t go wrong.
Peter Dunn a.k.a. Pete the Planner® is an award-winning financial mind and a former comedian. He’s a USA TODAY columnist, author of ten books, and is the host of the popular radio show and podcast, The Pete the Planner Show. Pete is considered one of the foremost experts on financial wellness in the world, but he’s just as likely to talk your ear off about bass fishing.