Help a Reader: Buying a Home

Here's an email I recently received from a reader:

I have been a long-time renter, but now married with 2 small kids I’m considering buying my first home. I’ve done some research and talked to some banks, but the thing that’s making me hesitate is that I’m worried that houses are overpriced because of the current low interest rates.

The way I’ve approached the home buying process, and the way I think most people do, is to see what kind of mortgage I qualify for, and then use that to figure out what kind of house I can buy. Currently I qualify for about a $500K mortgage at a 4.25% interest rate.  However, if the rate goes up to 6.25%, which is still very low by historical standards, I’d only qualify for about a $400K mortgage, which would mean that the prices of the houses that I could buy would decrease by 20%.

If this is the approach that most home buyers use, if rates went up to 6.25% home prices would fall 20% as everyone would only get a mortgage that’s 20% smaller. I know that if incomes rise along with the interest rates that wouldn’t necessarily happen, but I’m not optimistic that incomes will rise that quickly.

I really haven’t had much experience with this, so I’d appreciate you could point out any faults in my thinking.

What are your thoughts for him?

Comments

[Jon]

Well, first of all, as I told my daughter when she and her husband were house-hunting, never use the figure the banks, real estate agents and mortgage companies give you to determine what you can afford to buy. Their job is to make as much money off of you as they possibly can. Use your own budget. Most finance gurus will tell you not to buy a home that's more than a third of your budget. I personally would recommend staying at a quarter or less.
When it comes to home pricing, the "formula" by which home prices are determined is non-linear with interest rates, though prices will definitely decline by some small amount as rates rise, other factors are involved, such as what's available on the market, what builders are putting into homes, what the taxing authority assesses them for, what other homes in the area have sold for recently, etc.
So,
1. Don't buy all the house they say you can afford
2. Take advantage of low interest rates to lower your payments, but don't buy just because rates are low.

[ASR]

I share your concerns. Here are my thoughts: rising rates would likely mean a better economy and rising incomes, which would justify flat to increasing home prices. I understand that in prior rising rate environments home prices have generally risen as well. The flip side is that rates were so so low that we can't really know what is going to happen when rates normalize. Further, we may be operating on an incorrect assumption - i.e. rates may not rise substantially for along period of time due to low demand for money (i.e. read Larry Summers recent comments) Perhaps, the Federal Reserve should get out and let markets work. Yes, it may be painful, but it will put the recovery on more solid ground.

[Kathy]

Do NOT spend as much as the bank qualifies you for. There are always expenses associated with home ownership that take much more of your money that you expect. And don't be a diva like some people on those House Hunter shows who think they need a fabulous house to impress their friends when "entertaining". Do you really think that a stainless refrigerator keeps you food cold better than a white one? Will your friends drop you from their social circle if you don't have granite countertops or a spa tub? Make sure the furnace works or the basement doesn't leak before you worry about the color of paint on the walls or the fact that the shower enclosure is brass framed instead of frameless. So basically, learn about what is important rather than aesthetic.

[Joe]

I agree. Buy the house you can afford, not the one the bank wants you to buy.
We are thinking about buying a house as well, but we probably will wait a few more years for the market to cool down a bit. Mortgage rate isn't a big deal for us because we'll probably pay in cash.

[J R]

I agree with the posters above that what you qualify for and what you can comfortably afford are two completely different numbers. Also consider that homeownership brings with it several extra costs beyond the monthly mortgage. You are now responsible for your own maintenance, taxes, insurance, and perhaps an extra utility bill or two that may have been included in your rent prior to this. Expect your true cost of ownership to be an additional 40% or more to your monthly mortgage payment.

In my opinion, a better way to figure out how much home you can afford is find a mortgage calculator and plug some hypothetical numbers into it. You obviously have an idea where interest rates are and the term of mortgage. Play with the principal amount and see what monthly payment comes out. Add 40% or more and compare to your rent you are paying now. Can you swing that?

Regarding downpayment and savings, my biggest financial mistake to date is not coming to the table with 20% down. I only did 5% and the PMI is like throwing money away. If you can't put at least 10-15% down you can't afford a home. 20% is ideal. After that initial savings shock, you must leave yourself PLENTY of extra savings for the unexpected maintenance expenses (I had to replace my air conditioner, furnace, garage door opener, and three toilets to the tune of nearly $8K within a year... the carpet is starting to call my name now)

So obviously the banks want to qualify you to the edge of your financial situation. To remain securely within your comfort zone run your own numbers. Remember, only you care about your money.

[jim]

Your theory is that if interest goes up 2% then prices will drop 20%. In fact interest rates went up about 1% in the past 12 months or so and median home prices actually increased about 10% from Jan '13 to Jan '14. If you go back and look over time interest rates fluctuate up and down and home prices do not react directly to it.

Just because some people can afford less home due to changing interest rates doesn't mean house prices drop. If interest goes up what is more likely to happen is that people like you will pay more or settle for less house. Now there may very well be some impact due to interest but there are too many other variables and often its outweighted by other factors.
Logically you'd expect that if interest rates go up a lot then home prices may go down as a reaction. But it really has not worked that way.

[rick]

Whole the comments above are all correct they miss the big picture. Your personal residence is where you live and house your loved ones. Should the value decrease for a period due to rapidly rising interest rates that will not affect you so long as you have bought a house that meets all your needs and is affordable. You will simply keep making your low payment as a result of your now bargain interest rate and live in your affordable home. Rental rates will increase but your payment not so much. You will make the payment for a period of 15 to 30 years then be free. Since the payments have not been much more than rent for the first few years and are probably much less than rent the last few years you win even if the value gets below the original purchase price for some period. A free and clear home is a wonderful thing. Go ahead and buy what your family likes and that you can easily afford and remember a home, while it will probably be a good financial move, is primarily a place to make a life with your family.

[bubba_joe]

the above posters are correct, the bankers, mortgage companies, real estate agents are looking out for their best interests, not yours.

assuming you have already determined that you are planning to live in the location at least 5 years,
work the problem in reverse.

determine how much you are willing to pay per month.
multiply by 12 for total.
contact the local tax authority to determine property
tax rates. contact you insurance company to determine homeowner insurance rates.
subtract taxes and insurance from 12 month total.
then knowing the interest rate, and term (15, 20, 30 years) you can use excel to calculate monthly payments based. multiply the monthly payment times 12. this number should be close to the number after taxes and insurance. Now you know how much you can comfortably afford to finance.

[No Nonsense Landlord]

You are correct. When interest rates rise, monthly payments rise, and housing sales fall. It may limit the number of sellers, or cause prices to fall. Either could happen. What we recently saw was both. Lack of sellers, and the ones who did sell had to lower prices.

Once prices start to rise, there is a pent up demand to sell. Many potential sellers out there are landlords, just waiting to become “over water”. There are many sellers who want to move, but cannot. Those sellers too will sell once the markets rise in price.

So there are many reasons prices will not rise, and a few reasons prices will rise. No one has a crystal ball, and you may be able to look to Japan to see where our economy might head. Or look to the Weimar Republic and see what happened when they printed money.

Buying is better than renting, albeit a bit more expensive. There are many reasons to buy, including the wealth that it generally brings. If you want a fluid lifestyle, stay a renter. Since you are married with kids, a house might be great. If things don’t work out, an apartment is best.

So, you pay your money and you takes your chances….

[Apex]

While it may seem like housing prices and interest rates are directly and tightly correlated that is not the case in most instance. They are related but only loosely and far less powerfully than one would expect.

The last 15 years are a perfect example of the changes in correlation between housing prices and interest rates.

15 years ago interest rates on a typical mortgage were 7.5%. I know because I took one out. That was in 1999. Over the course of the next few years the dot com bubble occurred, followed by a recession and a modest lowering of interest rates, and prices rose (they had been rising since the early 1990s and then kept right on rising). Then the economy recovered and interest rates were raised back up a modest amount and prices kept on rising. Then they completely decoupled and rose by large amounts irrespective of interest rates.

Then the housing market collapsed and foreclosures became abundant. Interest rates were lowered to prices never seen in all of record history for mortgages. Interest rates got cut in half. By the logic of interest rates and housing being correlated housing prices should have shot even higher. But instead the cratered. They cratered for many reasons.

1. The previous price was too high.
2. The supply of housing was now abundant due to foreclosures.
3. The demand for housing was abysmal both because people were scared and because the banks would not lend to anyone.

Keep in mind that the excessive rise in prices happened with interest rates much higher than they are now.

In the long run everyone has to buy houses with wages so there is a connect between wages, interest rates, and housing prices.

However that works itself out over generations. In the end econ 101 and supply/demand still dominate.

Currently housing is too cheap. The price to rent ratio has never been lower (except when it was slightly lower a couple years ago).

There is a long ways to go before housing becomes unaffordable enough to be worried about excessive interest rates killing the housing price.

When interest rates are rising there are actually multiple things that will lead to house price increases as long as the interest rate rises are modest and not from excessively high levels:

1. The economy is in better shape which is why interest is rising, so people have more money in their pocket and are willing to spend more on housing.
2. People see rates rising and think they need to get a house now before the price interest rates get worse, this increases demand.
3. The overall feeling of the economy and the rising prices feed on itself and give people confidence and make them feel better about spending more on housing than they might in a stagnate or falling market.
4. Banks feel better about both the economy and the borrower and are willing to be more liberal with their lending policies increasing the pool of available buyers.

There are forces acting against those items as well but the point I am trying to make is that if you are worried about rising interest rates decreasing house prices only 1-2 years after the greatest sale in housing prices in modern history then you will never buy a house.

There will never be a better time to buy a house than right now. The only time that was better was 1 year ago, and the only time that will be worse will be sometime in the future.

If you don't buy a house right now because of a worry about interest rates, you will end up buying a house 3 years from now at a higher price AND at a higher interest rate.

Do not use fear of rising interest rates to stop you from buying a house. There may be very good reasons to not buy a house right now for you but concern about future interest rates is definitely not one of them.

Get a 30 year mortgage and don't ever think about the price of your house again.

[Old Limey]

Buying our home turned out to be an excellent investment as well as always living in very safe neighborhoods with excellent schools, a short commute, and great pride of ownership.

House #1
Bought a new 4br 2ba ranch style home on an 8,000 sf lot in Silicon Valley in 1963 for $26,950.
Sold it in 1977 for $90,000.

Home #2
Became the 2nd. owner of a 5 year old 4br 3ba ranch style home on a 12,000 sf lot, at the bottom of a court in Silicon Valley in 1977, about a mile away, and in a custom development of very individual homes for $107,000. Our 3 children were able to stay in their same schools, which was important to them. The children have been long gone but we still live in the same home, now have a gorgeous and very mature garden and love the home and its location more than ever even though we retired back in 1992. Houses rarely sell in the neighborhood but on Zillow it's valued at $1.5M.

We had conventional mortgages on both homes. By putting 25% or more down we were able to get the best interest rate available.

If you plan to still be living in the home when you are old (I'm 79, my wife is 80) I recommend that you don't buy a 2 storey home because you never know how mobile you will be in your senior years. We have found that it's also very handy to live close to all of the amenities that you will need, such as a supermarket, drug store, post office, ATM machine, Clinic, Dentist, and restaurants.

[AF]

Find a good realtor to help you navigate through what a good value is and isn't. There are many homes that are still a really good value. I tell my clients to look for poor photos, clutter, or a listing with only one photo. Those homes get overlooked and are many times a great value due to lack of competition among buyers. A strong realtor can help find a home not even listed, they can help negotiate good terms, and they can help to point out money guzzling repairs.

In addition, one of the first questions from your realtor should be "where do you want your monthly payment?" Taxes vary and so does insurance, so affordability accounts for much more than just the price of the home. Not all realtors are out for themselves, so shop around.

I also agree that the fear of rising interest rates should not be a determining factor. And on the other hand, the low rates shouldn't be a cause for a purchase if you aren't ready for the responsibility of home ownership.

[First time home buyer]

That was my email up at the top. Thanks everyone for the great advice. You've all given me a lot to think about. Especially Apex, your advice on real estate is thorough as usual.

I feel more confident in proceeding with the home buying process, but from hearing all of your advice, i realize that there's a lot more I need to do before actually buying a property.

Besides AF's comment above, any other advice for finding a good realtor?

[FMF Millionaire #19]

First Time Homebuyer

You have received an abundance of great advice from the FMF community. Let me simply add that you can usually find the correct answer to most financial questions by simply following the general principals discussed by FMF on this site.

Increase your cashflow.
Take debt in moderation.
Live below your means.
Save & invest for your future.
Embrace compounding early.
Start saving early.
Pay yourself first.
Strive to increase your net worth.
Prioritize money "in" over money "out"
Read the Millionaire next door.
etc....

Many of these principals apply to your question.

Good luck.

[getagrip]

IMHO at its core the reasons for buying a home for yourself are no different now than twenty or more years ago.

1. Buy because you want to. Not because someone told you it's an investment, or you think you should just because it's somehow expected of you.
2. As others have already said, figure out your budget and what you can reasonably afford, forget what you qualify for or what the bank says, they aren't the ones making the payments and living your life. Your budget should determine what you can and can't buy regardless of the interest rate.
3. Buy if you plan (not that you have to or necessarily will) to live in the area for at least 7-10 years. That's typically where you get better gains, since at that point you've recouped closing costs and your fixed rate mortgage payment turns out to be less than rentals of smaller homes or even two bedroom apartments in the area. Life can always throw a curveball or better opportunities can arise, but if you know for a fact you're out of there in three to five years, buying may not be the best bet financially.
4. Be realistic in what you look to buy. If you hate yardwork, a large lawn with tons of flowerbeds may look nice, but you'll either be paying landscaping fees or loathing spring and summer. Similarly, if you can't swing a hammer and have no willingness to learn, a fixer upper will never get fixed up unless you shell out a lot of dough paying someone else to do it. Know yourself, but also know if you want something and are willing to pay, just take that into consideration in the budget.
5. Know your neighborhoods. A good realtor should know the school districts, the area, what's going on and being built nearby, etc. You'll want to drive around yourself and see if there are issues you may not want to deal with in the area.

Best of luck.

[joe]

unless you have an ARM dont worry about interest rates going up - lock in a 30 yr mortgage and pay a point or two to get your lowest rate. the market is still 20% below its 2008 top. get a very good house inspector and get a clue report on the house so there are no surprises.

[Mike]

In all the above comments, nothing is said about buying what you need as opposed to what you can afford or budget for. Buying a bigger home than you need adds to your expenses in many ways, heating and cooling, cleaning, upkeep, and on and on.

Determine first how much home you need and then determine how it might fit into your budget.

[moronbuffet]

fools buy houses; wise men live in them - Chinese proverb