Recently, we have seen numerous diaries here discussing various gloom and doom scenarios for the US economy and how these possible events would affect us. We've talked about foreign debt exposure, a possible dollar dump, the rise of China, a `unified' Europe, world opinion of the U.S. vs. our future growth, exporting manufacturing jobs, interest rate hikes, and an imminent housing bubble (whew). Anybody reading these discussions would naturally be a `little apprehensive' regarding their financial affairs. I admit it - add me to the list of nervous Kossacks.
Logically, it is the last item on the list that has the potential to hit hardest on most Americans. One of the few positive statistics Mr. Bush can highlight without mentally crossing his fingers behind his back is record levels of home ownership. But to hear some people say it, this ultimate expression of the American dream has the potential of crashing down on us all like a house of cards.
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I have read many articles and a couple of books on the housing bubble in the past six months and can point to just about any opinion you would like to see. I've seen `condos rule vs. condos suck', `ARM's are great if you sell within five years vs. ARM's will doom us all', `Buy on the coasts (you never lose) vs. California, Florida and New York will be the hardest hit', and so on. The bottom line appears to me to be that half the `experts' think everything will be fine, the other half are worried. Great - thanks everyone for the help!
So how do we make sense of all this talk? Is there some way to look at this objectively? If so, how? Let's give it a try...
First, the facts:
- The vast majority of Americans borrow to buy their homes.
- Interest rates are at historic lows.
- Home ownership is at an all time high, and land is a limited resource.
- Interest rates are rising, with the average 30-year mortgage rate at just over 6.0 percent vs. 5.4 percent a year ago.
The best way I can think of to objectively look at this is to bring it down to the individual level. Two examples follow with both using the same basic assumption - interest rates will continue to rise to 7.4 percent for a 30-year mortgage at some point in the near future. This is two points higher than last year's low. Feel free to debate the reasonableness of this assumption.
Example 1: Pineapple Upside-Down Cake
Mark and Mindy are a couple in their mid-30s with a new baby. They purchased a great $500,000 home in Seattle in early 2004, paying 5% down with a 30 year, 3.3% adjustable rate mortgage (ARM). Mark is an accountant at a senior's center and earns $50k per year. Mindy is a nurse at the same location who made $60k in 2003 with overtime. They used their combined salary to `easily' qualify for their home mortgage. With the baby's arrival, Mindy has cut back her hours and should earn about $35k in 2005. Their current house payment is $2,080 per month, or just 23% of their 2003 pre-tax earnings.
What happens when their initial ARM term is up and the new rate is 7.4%? Their house payment jumps 58% to $3,288 per month! This is now 46% of their combined current pre-tax earnings. Put another way, they should have about $1,700 per month after payroll taxes and the house payment to spend on car loans, credit card debt, utilities, property taxes, insurance, gas, food, entertainment, diapers, day care, retirement savings and the college fund. Sorry guys, doesn't look like you can afford to have that second child quite yet.
Depressing, no? I have no real suggestion for poor Mark and Mindy other than consider locking in now, and prepare for some very stressful times ahead.
Example 2: He who speculates...
Sam and Rebecca are living in Miami and are doing very well for themselves. They own a house appraised at $600k and thanks to the boom, they have over $250k equity in their property. Between the equity and $50k they've managed to save, they decide to speculate on a downtown condo project. They buy a two bedroom unit with an ocean view at the bargain pre-build price of $450k. They pony up the $50k and will borrow `only' $65k against their existing home equity to put down 25% on the condo and pay closing costs.
Can't lose, right? Well, let's look at what happens when the condo is finished and they want to sell. About that time, Ricky and Lucy are in the market to buy. They have $30k saved and would like to pay under $1,900 per month but can go up to $2,100. Under today's environment of ARM's and low down payments, they could afford to pay up to $500k (just like Mark and Mindy above) with 5% down and a 3.3% variable rate. But, by the time rates increase Ricky is reading about people like poor upside-down Mark and Mindy so he decides no ARM and Lucy says we must put 10% down or we don't buy. They go to their bank and pre-qualify for a $270k 7.4% 30-year mortgage with guaranteed payments of $1,870, allowing them to pay up to $300k for their new home. They love the condo, and put in the $300k offer.
Suddenly, Sam and Rebecca don't look so smart. They have three choices - sell at $300k (losing $150k, $50k in cash and $100k from debt), find a way to pay a $2,300 monthly mortgage plus regime fees until prices go up again, or hope to find someone else who can afford to pay more than Ricky and Lucy. Ouch.
Conclusion:
All this pain from a lousy two percent rise in mortgage rates? It looks possible to me.
The conclusions I draw from the above two examples are:
- Real estate, like most investments, is for those who can afford to play for the long term. This is especially true in today's environment.
- Be very wary of the Adjustable Rate Mortgage. Use with extreme caution.
- If you want to speculate, only invest what you can afford to lose. You can lose.
It is the effect of monthly payments that will drive real estate values in the short run. In the long run, the value will be there but plan for the short term effect of interest rates and monthly affordability.
I know what they say about taking advice (or candy) from a Stranger. But for what it's worth, my advice to any Kossacks considering jumping into the real estate market is to be careful out there. I have no idea if the bubble is really going to burst, but since the possibility exists, recognize the risk in your decision.
BTW - the above examples are real, only the names have been changed to protect the innocent. For Mark, Mindy, Sam and Rebecca, I hope these possibilities do not come to pass.
Finally - All mathematical, grammatical, theatrical, systematical, hydromatical, and ultramatical errors belong to the author alone.