Unfortunately for many who have faced an unexpected income interruption, the dream of buying their first home will likely need to be delayed until they can resume employment and then prove to lenders that their income is back to a sustainable level. For those of us fortunate to be able to continue our careers working remotely, we have had more time than we could have ever imagined sitting in our homes and wondering what we might prefer different from our current living situation in the years ahead.
This recession is unique in that there are two conflicting forces related to home affordability: Nationwide home prices are holding firm near record highs, but mortgage interest rates have dropped to record lows. Below is a chart of a home price index for the largest 20 U.S. cities compiled by Standard & Poor’s:
This index began in January 2000, so the index shows price movement relative to that date. Note how the index rose more than 100% from 2000 to 2006 but then abruptly fell more than 25% through early 2009 during the Great Recession. Notice in 2020 how well home prices have held up through June during the COVID-19 pandemic.
The following table shows a nationwide average interest rate for a 30-year fixed-rate mortgage as compiled by Freddie Mac’s Primary Mortgage Market Survey:
While home prices remain elevated, lower interest rates are enticing those who are financially capable of making that next step to call their banker and get the mortgage process underway. Banks will look at your personal finances carefully to determine if you qualify for taking out a new loan, either for your primary residence or a vacation home. They will compare your earnings relative to your ongoing debt obligations to compute some ratios that you will likely need to fit within for loan approval:
Consumer Debt Ratio: Monthly Nonhousing Debt Payments ÷ Monthly Net (After-Tax) Income = Keep Under 0.20
- Monthly minimum payments on student loans, auto loans, credit cards = $1,200
- Monthly paycheck after taxes = $7,000
- Consumer debt ratio = $1,200 ÷ $7,000 = 0.17 … This is below 0.20, so that is good
Housing Cost Ratio: Monthly Nondiscretionary Housing Costs ÷ Monthly Gross (Before-Tax) Income = Keep Under 0.28
- Monthly mortgage payment, property taxes, home insurance, association fees = $2,500
- Monthly paycheck before taxes = $10,000
- Housing cost ratio = $2,500 ÷ $10,000 = 0.25 … This is below 0.28, so that is good
Debt-to-Income Ratio: All Debt and Housing Costs ÷ Monthly Gross Income = Keep Under 0.36
- Combine the above items: $1,200 + $2,500 = $3,700
- Monthly paycheck before taxes = $10,000
- Debt-to-income ratio = $3,700 ÷ $10,000 = 0.37 … This is above 0.36, meaning one of the following: You will need to pay off some auto/student/credit card debt to qualify for a loan, your mortgage may be subject to a higher interest rate, or you should consider a lower-priced home
Assume that you will need to reinvest 1% to 2% of the home value back into the property each year in ongoing maintenance and repairs, so have that factored into your ongoing budget ahead of time.
You should also make sure that the overall expenses with homeownership still allow you to pursue other financial goals, like saving roughly 15% of your pre-tax income for retirement savings and having adequate cash flow to save for kids’ college education. The same analysis can apply to a second home purchase if you just add the additional expenses of the second home on top of your primary residence costs to see if the above ratios are still satisfied. If the numbers look good with the value of the home you want to purchase, and the home purchase would not impede your other financial goals, then approach several local banks to get some loan quotes and review bankrate.com to review quotes from nationwide providers.
Young professionals should focus on a 30-year fixed-rate mortgage to lock in a low rate that isn’t subject to rate increases and that will stretch out the repayment horizon so that your monthly payment is lower. This will allow you to have additional monthly cash flow that you can add to your retirement and investment accounts, which over time should earn a rate of return higher than your mortgage interest rate. In other words, paying the minimum payment on your mortgage and investing the rest should serve you well over a long mortgage term.
For midcareer professionals considering upgrading homes or buying a vacation home, it may make sense to pursue a 15-year mortgage so that your mortgage payment is scheduled to end once you approach your targeted retirement date.
Reviewing these specific decisions with your financial advisor within your comprehensive financial plan can help you review the various options to hopefully give you confidence in your decision. Please reach out to your advisor if we can help run some scenarios for you!