Mortgage rates don't matter
With negative gas in my tank, I am counting down the seconds to putting up my out of office notification for the holidays. But I’m not throwing in the towel just yet. In this week’s newsletter, I am going to show you how to figure out if you can afford to buy a home no matter what rates are.
People used to think millennials would never own homes. We would all simply live in our parents’ basements, drowning in student loan debt while cuddling our high school trophies. But according to Freddie Mac’s “Millennials and Housing” playbook, homeownership rates have accelerated over the past five years. In 2019, millennials represented nearly half of the Freddie Mac purchase loans, and those were pre-COVID times. The pandemic sucked up housing demand like a Dyson vacuum, but I don’t need the data to tell me what I already know.
In just a handful of years, my family went from being the youngest on our block to watching a daily parade of strollers up and down the street. Waitlists at local preschools are consistently full. Black San Serif house numbers – the true sign of a new millennial neighbor – are popping up everywhere. The anecdata tells the same story: against all odds, we are here.
This does not mean homes are affordable. Measuring affordability in any objective sense is silly, because what’s affordable for one buyer may not be for the next. Yet, when the news examines affordability in the housing market, they focus almost exclusively on one thing: interest rates.
Mortgage rates were falling even before the Fed pumped $7 trillion into our economy. By the end of 2019, the average 30-year mortgage was around 3.65%, according to FRED. By the end of 2021, rates dropped another 1% due to COVID. Existing homeowners pounced on the opportunity to refinance, but first-time buyers struggled to compete in the white-hot housing market. Unless you had tons of cash and were willing to assume a pretty reckless amount of risk (i.e. waving inspections and appraisals), you were never really playing the game. And then this year, when the Fed aggressively raised rates, they sent the pendulum swinging hard the other way. Thirty-year mortgages in the two’s just a few years ago are now north of six percent. Higher borrowing costs seem to have caused prices and demand to cool a bit, but there has yet to be a major pullback in the broader residential real estate market. At least inspections, appraisals, and standard financing terms appear to be normalizing.
I understand why interest rates are a hot topic, but why are they the only topic? When you are looking to purchase a home, rates dictate costs and pricing to some degree, but the true barometer of affordability goes beyond that. I focus my clients’ energy on answering two simple questions:
How much does the home cost?
When are you buying the home?
Knowing the price of the home lets you figure out how much cash you’ll need to buy it. And no, I don’t just mean the down payment. Closing costs will run another 3-5% of the mortgage amount. You will have “wants” and “needs” for improvements, repairs, and furnishings, which many people have to prioritize at the jump, depending on how flush with cash you are. In 2016, when we bought our first home as a young family, we most certainly were not flush. Our home had beige walls, a retro double-sided fireplace, no window treatments, and a geriatric HVAC system. (Can you guess which we handled first?) You should also leave enough money aside for a healthy cash reserve, because no one wants to be down to their last dollar after completing the biggest transaction of their lives. Home ownership is too unpredictable for that.
Example: Putting 20% down on a $500,000 home requires $100,000. Closing costs are generally 3-5% of the mortgage amount and include items like lender fees, prorated property taxes, inspection, appraisal, attorney fees, title search, and insurance fees. Let’s be conservative and use 5% of a $400,000 mortgage, or $20,000 for closing costs. Then, add another $20,000 as a budget for anything you might need to work on. Lastly, let’s make sure you have a cash reserve of $35,000. In total, your cash requirement for this home is $175,000.
Once you know how much cash you need to purchase the home, you’ll need to determine how much cash you’ll need to stay in the home. There’s no shortage of mortgage calculators on the internet, but I’ve been using MortgageCalculator.org for years. It’s very good. Enter the purchase price, down payment, mortgage rate, insurance cost, and property tax estimate, and you will get a realistic monthly amount. Using the example above, I came up with a monthly payment of $2,664.
With your costs figured out, you can address timing. Timing helps us understand how much money needs to be saved on a monthly basis to buy the home. In the example above, you need $175,000 to comfortably buy a $500,000 home. Let’s assume you’ve done a good job saving already and have $125,000 in the bank. You want to buy a home in two years? With $50,000 left to save, you need to set aside $2,083 per month for the next 24 months. Easy maths!
By working through just two questions, you have an entire system for determining whether buying a home is affordable, irrespective of the clickbait headlines about interest rates. The truth is, I’ve seen high earners not have enough cash for a down payment and super-savers unable to fit their mortgage payments into their monthly budgets. Affordability is a personal calculation, and only after you’ve completed your own can you determine whether your finances support any number of scenarios, like what happens if you put more/less money down or if rates keep fluctuating. In any event, you must address affordability as a whole before losing yourself in the sexier considerations, like how many big homes are on your block or how close you are to the train station. None of it really matters if you can’t afford to live comfortably.
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