Is Now a Good Time to Buy Real Estate?
Finding the perfect place to call home can be fun. It can also be a daunting task. In fact, buying a home is probably going to be the biggest single purchase you ever make, in the short and long term. You have to come up with a sizable down payment in the short term, but, over the long run, home ownership provides a hedge against inflation. Homeownership is also seen as an investment to help you in retirement.
Because so much is at stake, it’s not only important to buy in the right area, but it’s also imperative that you get into the real estate market at the right time. And you have to decide whether you want to buy an existing home or buy a new one.
First-time homebuyers also need to have a comprehensive understanding of how interest rates affect their mortgage and what rising rates will mean to their day-to-day lives. After all, interest rates might be near historic lows, but they will eventually start to rise again. Understanding how interest rates affect mortgage rates can save potential homebuyers thousands of dollars in interest charges over the life of the mortgage.
There are a large number of factors to consider before answering the proverbial “Should I buy real estate now” question.
Are Ultra-Low Interest Rates Here to Stay?
On the surface, the roots of America’s financial crisis can be traced back to 2007 when the U.S. housing bubble burst. This sent the dominos tumbling and the United States into an economic meltdown in 2008.
But the fact of the matter is that the roots of the Great Recession can be traced back further. Residential homeownership in the United States peaked in June 2004 and began a rapid decline from there.
Over the ensuing years, excessive borrowing fueled a housing boom that was followed by the collapse of real estate values and housing sales. The one asset class Americans had been told was rock-solid was anything but.
By early 2012, housing prices in the U.S. fell 33%, surpassing the 31% slide that began in late 1929 and lasted until the early 1930s. This illustrates not just how far real estate prices fell in the Great Recession, but it also shows that the housing crash was bigger and faster than the one during the Great Depression.
In an effort to help kick-start the U.S. economy, the Federal Reserve initiated its first round of quantitative easing in late 2008. The bond-buying program sent short-term interest rates (which impact short-term borrowing like mortgages and loans) tumbling to near zero.
While the federal funds rate is not tied directly to mortgage rates, it does influence them indirectly, as it impacts lenders’ borrowing costs. If it’s more expensive for a bank to borrow money, they will pass that extra cost on to consumers.
The U.S. central bank used its quantitative easing program to buy bonds to help keep mortgage rates low. Conversely, the Federal Reserve can decrease its bond-buying program, which would send mortgage rates upward.
It was expected that the low interest rate environment would encourage banks to lend more money to businesses and people. This would encourage consumer spending and reduce the country’s cost of debt.
The ultra-low interest rates were also expected to send first-time homebuyers into the market. Unfortunately, high unemployment, high debt levels, and stagnant wages meant most potential homebuyers couldn’t actually take advantage of the record-low rates.
In fact, even after implementing quantitative easing in 2008, the U.S. real estate market didn’t bottom until January 2012.
U.S. Housing Rebounds but Lots of Room to Grow
While U.S. housing prices rebounded in 2012, despite affordability, there is a lot of room for growth. U.S. home prices have risen more than 23% since 2012, but they still need to rise an additional 22% to simply reach their pre-recession highs.
Chart courtesy of www.StockCharts.com
There is a lot of room for growth. This is good news for first-time homebuyers, since housing prices will not escalate until inflation rises and drives housing prices higher. As it stands right now, interest rates are expected to remain low and inflation is expected to stay in check. As a result, the inflationary advantage of ownership is not yet in place.
Can eager first-time homebuyers take advantage of the current real estate market? To prevent a similar real estate crash from happening again, and to prevent homeowners from defaulting on loans they cannot afford, banks changed their underwriting standards. More than four out of every five mortgages now require a down payment of 20% and credit history standards have tightened.
Today, the rate for a 30-year conventional mortgage is around 4.2%—an historic low. Mortgage rates have fallen even though the Federal Reserve has been cutting back on its generous monthly bond-buying program, which is designed to keep long-term borrowing rates low.
That said, the Federal Reserve’s quantitative easing measure is expected to finish at the end of October. While this would normally mean an increase in interest rates, the Federal Reserve has signaled it will continue to keep rates artificially low.
Now technically, the Fed doesn’t control consumer rates directly, but it sets the federal funds rate; this is what banks pay to borrow money from one another. In theory, when the federal funds rate is low, banks have more money available to lend, and consumers can borrow at lower costs.
The Fed has kept the federal funds rate near zero percent since the financial crisis in 2008, but it can’t keep it at the bottom forever. The Federal Reserve has said it won’t increase its key federal funds rate (which impacts short-term borrowing like mortgages and loans) until the U.S. economy is on stronger footing.
Some have predicted mortgage rates won’t begin to rise until late 2015. And even then, it is expected that interest rates will be kept near historic lows (two percent) until at least 2020! For potential homeowners who can meet the tightened lending rules and have saved enough for a down payment, this is encouraging news.
The State of Existing- and New-Home Sales in America
According to the most recent data, there is a tale of two worlds in U.S. real estate. Sales of new homes soared 18% month-over-month in August to a seasonally adjusted rate of 504,000. Economists had forecast a rate of 430,000. The August data was also up 33% year-over-year.
But the growth was not coast-to-coast. New-home sales in the West jumped 50%, while new-home sales in the Northeast were up close to 30%. New-home sales in the South climbed roughly eight percent, while new-home sales in the Midwest were flat. The median sales price for new homes was $275,600 in August, compared to $280,100 in July.
While this is welcome news for the real estate market, the U.S. is still a long way from a full-fledged recovery. On top of that, new-home sales only account for roughly nine percent of the overall housing market. While the new-home sales data is encouraging, it is still well below the one million mark economists say is indicative of a healthy real estate market.
What about existing homes? Sales of existing homes slipped 1.8% in the most recent month to an annualized pace of 5.05 million from the 5.14 million rate in July. The sale of properties sold to investors was the lowest in almost five years. All-cash purchases fell to 23% from the usual 33%.
The all-important first-time homebuyer accounted for 29% of the market, well short of 40%—the number most economists think is ideal. First-time homebuyers have been held back from taking advantage of record-low mortgage rates in large part by stagnant wages and tighter lending rules.
Can You Handle Higher Interest Rates?
Some first-time homebuyers might also be scared off by the idea of rising interest rates. It’s one thing to get a mortgage in a record-low interest rate environment; it’s another to be able to handle rising interest rates.
Essentially, it’s important to understand what kind of debt load you can handle—and how your lifestyle will change when interest rates rise. Because they will. For first-time homebuyers or those with mortgages coming up for renewal, that means the cost of borrowing money is going to steadily increase. And even a small increase can add up fast.
For example, a $250,000 mortgage with a 25-year amortization period at 4.2% translates into a monthly payment of $1,342.30. Over the lifetime of the mortgage you would pay out $402,688—or $152,688 in interest.
What happens if interest rates rise to five percent when it’s time to renegotiate? That $250,000 mortgage would cost you $1,454.01 per month—an extra $1,344 per year. And the amount you pay out in interest jumps to $186,204.
It’s inevitable that interest rates will rise; by most accounts, they’ll inch higher in late 2015. The big question is: will Americans be able to handle the higher interest rate environment?
U.S. Housing Remains Affordable
For now, lower mortgage rates, a cooling U.S. housing market, and an improving economy have made owning a home in the United States very affordable. The average price growth has slowed, rising just 6.4% in August of this year. That’s down from annual average gains of as much as 12% near the end of 2013.
On top of that, as previously mentioned, the U.S. housing market has plenty of room to run. U.S. housing prices have climbed more than 23% since the beginning of 2012, but they still need to rise more than 20% to just match their pre-recession levels.
According to one housing index, Americans generally feel more positive about the housing market compared to the beginning of 2014. In January, the index was 63.7 and increased to 64.2 during the summer. The index is measured on a scale of zero to 100 and a reading above 50 indicates positive market sentiment. (Source: Halliday, A., “Latest Research Shows Increasing Confidence in Real Estate,” Realty Biz News web site, October 8, 2014; )
The index looks at 20 major metropolitan areas. It also considers market trends, buying and selling conditions, predicted changes in home values, home affordability, home buying plans, and attitudes towards homeownership.
In addition to being more positive, potential homeowners expect U.S. real estate growth to be more moderate going forward, with home values climbing roughly three percent in 2015 compared to 6.6% over the past year.
This data echoes similar results found in the National Association of Realtors (NAR) Housing Affordability Index. This index measures whether or not a “typical” family can qualify for a mortgage loan on a typical house. A “typical house” is defined as the national median-priced, existing single-family home as calculated by the NAR. The “typical” family is defined as one earning the median family income as reported by the U.S. Census Bureau.
A value of 100 means a family with the medium income has exactly enough to qualify for a mortgage on a median-priced home. An index reading above 100 means a family has more than enough income to qualify for a mortgage loan (assuming a 20% down payment).
A Home Affordability Index reading of 120 means a family has 120% of the income necessary to qualify for a typical home. An increase in the index means a family is more able to afford the median-priced home. Conversely, a lower reading suggests affordability is eroding.
In 2011, the starter home price averaged $141,300. The First-Time Buyer Index stood at 123.1, while the Composite Index was 186.4. By 2012, the average starter home price had risen to $150,600, while the First-Time Buyer Index rose to 129.7 and the Composite Index climbed to 196.5. (Source: “First Time Home Buyer Affordability,” National Association of Realtors web site, August 12, 2014; )
Last year, the starter home price climbed to $167,800. The First Time Buyer Index slipped to 115.9 and the Composite Index also retraced to 175.7. According to the most recent data provided by the NAR, for the second quarter of 2014, the price of a starter home was $180,500, the First Time Buyer Index was 105.6, and the Composite Index was 160.0.
Housing may still be positive, but affordability is waning. Since 2011, the price of a starter home has risen 27% to $180,500—at the same time, the First Time Buyer Index has slipped 14% to 105.6.
Housing Affordability Also Depends on Where You Live
In 2006, at the peak of the housing market bubble, U.S. home prices were overvalued by an estimated 34% before dropping to 13% in the first quarter of 2012. Today, seven percent of the largest 100 metropolitan housing markets in the U.S. are considered to be overvalued by more than 10%. That might not sound like a lot, but it’s the highest number since the first quarter of 2009.
And even then, it’s about location, location, location.
Some of the most overvalued markets are on the red-hot west coast. Austin, Texas is overvalued by 19%, followed by Los Angeles (15%), Orange County (15%), San Francisco (12%), and Riverside-San Bernardino (11%). Almost all of the most undervalued metropolitan areas are in the Midwest and on the east coast. For example, Dayton, Ohio is undervalued by 21%, Cleveland by 19%, and Detroit by 18%.
So, what will the U.S. housing market look like in 2015?
While some pundits have predicted U.S. home prices will continue to fall over the next few years, the fact of the matter is that it’s difficult to accurately predict where the housing market is going.
What we do know is that interest rates remain near historic lows and the U.S. economic environment is improving. At the same time, weak construction, stagnant wages, and high youth unemployment point to housing prices remaining stable.
The most important considerations will be getting the best mortgage and preparing for higher rates. Those who choose to max out their mortgages will be hit with bigger interest rate increases when it comes time to renew their mortgage. That will translate into higher mortgage payments and less money for household expenses.
As a result, it appears as though 2015 will be a good year for first-time homebuyers looking to get onto the property ladder.