Every buyer in every real estate cycle faces challenges. Buyers who can keep things in perspective still qualify for mortgages and sign contracts for homes.
NEW YORK – The housing market has been crazy for the past several years, and the recent spike in interest rates has only exacerbated the situation for clients who are looking to buy – and thinking about borrowing to do so.
Here are some ways they can stay in the game and not let the pursuit of their American Dream turn into a nightmare.
Plunge ahead
It’s understandable if concerned clients look at the high housing prices, rising rates and low housing supply and decide to hold off on buying a new home for a while, or for forever. But there is no guarantee that any of those variables are going to become more buyer-friendly any time soon. And in the meantime, clients are spending time in a house, neighborhood or city other than where they would rather be – or worse yet, spending money on rent that they’ll never get back.
The obvious initial solution is for clients to look for a home that is smaller than they originally intended, or perhaps located in a neighborhood in which demand is not so high. They could also buy a home that needs significant updating or remodeling, and endure those conditions until they can afford to make the improvements.
What about the rates?
Clients may also balk at buying a house when they learn that rates on the 30-year mortgage have jumped from 3% last year up to over 5% now. That’s certainly a negative development, but it’s not as dire as would-be borrowers would believe.
Let’s say your clients were planning on purchasing a $500,000 home a year ago, had $100,000 for their down payment, and were going to finance the remaining $400,000 on a 30-year mortgage at 3%. Their monthly payment would have been about $1,686. With the same figures but the rate now at 5%, that new monthly payment would be about $2,147, an increase of about $461 per month – an unfortunate extra cost, but hopefully not enough to make the home purchase beyond your clients’ reach.
But even if that’s an insurmountable figure for your clients’ current situation, they shouldn’t give up just yet.
Pivoting with reality
If the clients’ maximum monthly payment is the aforementioned $1,686, with a 5% 30-year mortgage they could still afford to purchase a $400,000 home with the $100,000 down payment. Or they could purchase the same $500,000 home, and (if they have the funds) put $200,000 down to keep the mortgage payment at $1,686.
They could also consider a mortgage with a shorter term, which would involve a lower interest rate (the 15-year mortgage rate is currently around 100 basis points lower than the interest rate of a comparable 30-year mortgage). However, even with a lower rate of the 15-year loan, the payments would be considerably higher: $400,000 borrowed at 4% on a 15-year loan has a monthly payment of about $3,163 – about a $1,000 more per month than the payment for a 5% 30-year mortgage.
Finally, they could talk with the lender about getting an adjustable-rate mortgage (ARM). The current rate for a 5/1 ARM (fixed for the first five years, then potentially adjustable annually afterwards) is currently slightly less than 4%.
But adjustable-rate mortgages can be harder to obtain than traditional fixed-rate loans. And after five years, the interest rate may actually rise. Therefore, an ARM is best for homeowners who think/hope they will be able to refinance with a lower fixed-rate mortgage some time in the next few years, or are only going to be staying in the home for the next five years or so.
Points: An end-around strategy
There is a potential solution for those clients who are likely to stay in their prospective home for the foreseeable future but can’t afford (or stomach) the higher payments of the new 30-year rate or a 15-year mortgage and don’t want to take the interest rate risk of an ARM.
First, they should talk with their lender to see how much it would cost in initial “points” (an upfront fee paid by the borrower) to reduce the interest rate on the new 30-year mortgage so that the clients can afford the monthly payment.
According to Bankrate.com, depending on the lender, the points usually cost about 1% of the total mortgage amount for each 0.25% by which the rate is lowered. Therefore (in theory) on a $400,000 mortgage, the clients could pay $32,000 to reduce their interest rate from 5% down to 3%. They would have to stay in that house for a little less than six years before the lower monthly payment on the 3% mortgage would make up for the $32,000 worth of points paid initially.
Private mortgage insurance (PMI)
That extra cost of the points could eat into their potential down payment, which may eliminate the buyers’ ability to make a down payment of at least 20% of the purchase price (therefore requiring the homebuyers to obtain “private mortgage insurance”).
The cost of PMI depends on several factors, including the size of the down payment and the borrowers credit history. But somewhere in the range of an annual cost of 0.5% of the original mortgage amount is a reasonable place to start for our hypothetical client buyers. That means that these borrowers would have to pay an additional $166 per month in PMI on their $400,000 mortgage.
And that PMI cost is not likely to last forever – it could be cancelled as soon as the homeowners’ equity exceeds 20% of the home’s value, whether that’s due to an increase in price, or paying down the mortgage, or both. Under the Homeowners Protection Act of 1998, the lender is generally required to cancel PMI once the borrower’s equity in the home reaches 22% of the original purchase price. In the meantime, the clients will still be able to (hopefully) enjoy the home of their dreams, and a low mortgage rate that they may never be seen again.
© 2022 Penton Media. Kevin McKinley is principal/owner of McKinley Money LLC, an independent registered investment advisor. He is also the author of Make Your Kid a Millionaire (Simon & Schuster).