Buying Homes Amid Rising Interest Rates: Understand This
NEW YORK ( MainStreet) As interest rates rise, real estate inflation just has to come down.
Pull out any mortgage calculator , and it's obvious. A 30-year fixed rate mortgage of $250,000 at 3%, on a $300,000 house, comes to $1,366 per month. At 4% the same mortgage costs $1,506. At 5% it's $1,654 per month.
The mortgage payment on a 30-year fixed-rate loan is a basic measure of affordability. Most bankers think this should be no more than one-third of your income. So if long-term interest rates rise from 3% to 5%, the income you need to qualify for that $250,000 mortgage rises from $40,000 a year to almost $50,000 a year.
During the housing bubble, this discipline disappeared. Buyers were taking mortgages that represented 40% or more of their income. Some were taking 40-year mortgages. What has changed now is that people can't qualify for those loans. Banks now want to be paid back.
The price of money, thus, has a huge impact on housing values. When I first bought my home in 1984, I was only able to get a 30-year, adjustable rate mortgage, at about 10%. My monthly payment was $535. At 3.5%, today's prevailing rate, that loan would cost under $200 per month.
This has brought discipline back to most housing markets. Absent other factors, it means that as interest rates rise, the relative value of real estate, compared with other investments, has to fall. You buy a home to live in it.
Homes are more purchases than investments for another reason. Each time you move, each time you buy-and-sell a home, you lose at least 15% of your equity.
Add the 7% commissions on your sale to the 7% commissions on your purchase, add in the cost of moving your stuff, and that's what you have to make up in order to break even. That's why young people should buy bad homes in good neighborhoods if they can. It's a lot cheaper, in the long run, to get a home improvement loan than to chase bigger-and-bigger houses.
Two other financial factors make a big difference in home prices:
- Past profits, which define how much of a down payment you can make, and thus how big your loan will have to be.
- Income, which defines how much money people in the area have to pay for mortgages.
The Great Recession destroyed a lot of peoples' past profits. Those who bought during the bubble wound up "underwater" on their mortgages, owing more to banks than what their homes were worth. If they got out from under that, through a "short sale," they're out of real estate cash.
Markets with high rates of short sales have less competition from local buyers. Some, like Las Vegas, have made up for this with high rates of foreign investment, investors speculating that they can make money both on the rent and the recovery.