A little over a year ago, a friend of mine reached out to me to ask - Should she be purchasing a home now? She had been saving up for a down-payment on her first house, so she was paying close attention to what was happening to interest rates. Mortgage rates were on the rise, and she believed they would continue to rise. She hadn’t saved quite as much as she had wanted. However, watching interest rates inch higher week by week was making her wonder if she should bite the bullet and buy a home before rates got out of hand, even though her down-payment wouldn’t be as big as she had planned, and the mortgage payment would be higher than she had wanted.
My friend was struggling with the decision of when to purchase, because higher rates can significantly increase the cost of owning a home if you’re borrowing. The difference between a 4% interest rate versus a 5% interest rate can mean tens of thousands of dollars of interest paid, depending on how long you hold the mortgage. Timing the purchase when rates are at historic lows can make homeownership a reality for some people who might otherwise not be able to afford a new house.
Predicting Interest Rates
The problem is, predicting what’s going to happen to mortgage rates is a bit like trying to predict what’s going to happen in the stock market. It’s not easy. I’d argue that it’s not even possible, at least not consistently. You might think that mortgage rates tend to follow the trends in the federal funds rate, but that’s not necessarily true. The federal fund rate does have an effect on mortgage rates, but mortgage rates are affected by other factors, too. With that said, even if they did correlate with the federal funds rate, you can’t predict the federal funds rate, either, so that wouldn’t even be that helpful.
When it comes to rates, one thing to consider is that if you do purchase (or refinance, for that matter) now, you might be borrowing at historically low rates. The average rate on a 30-year fixed-rate mortgage in July of 2019 was 3.77%, which is the lowest average since February of 2016, according to Freddie Mac. The lowest it’s been since the data was tracked beginning in 1971 was in December 2012, when it was 3.35%. So, 3.77% is darn good. That doesn’t mean you should count on low rates to continue. It also doesn’t mean rates are bound to go up. We simply don’t know what is going to happen to rates, so basing your home purchase on the timing of mortgage rates simply isn’t wise.
Consider The Housing Market
Another factor that comes in to play – a factor that my friend wasn’t considering – is that when rates are historically low, housing prices tend to be historically high. Sellers have an incentive to raise prices when they know the buyer can get cheap financing, and vice versa. Home price changes aren’t as extreme in some geographic markets, while other markets experience a lot of price volatility. In any case, you need to consider the housing market in addition to interest rates when deciding on whether to purchase a home.
Focus On What You Can Control
If you’re thinking about purchasing a new home, don’t focus on what you can’t control. Instead, focus on what you can control. You can control how much you save towards your home for a down-payment. Keep in mind that a small down-payment might mean you have to pay PMI as part of your monthly payment, which is essentially insurance for the lender. A small down-payment means your loan is higher risk, so PMI helps protect the lender if they ever had to foreclose on your home, and if the proceeds from the sale of the home weren’t enough to pay off the mortgage.
You can also control who you choose to use as a mortgage lender. Get quotes from a few different loan officers to see who offers the lowest rates. Keep in mind that the lowest rate doesn’t always mean you’ll have the best experience; you might prefer to work with someone who has more experience, works for a bank you already use, or who you trust because they were referred by someone whom you trust. You should weigh the pros and cons of working with different lenders, and cost is certainly one of those factors.
Another thing you can control is how expensive of a home you choose to purchase. Sure, you can’t control if the house you’re eyeing changes its asking price from one week to the next, and you can’t control how many other buyers are going to place offers on that house. But, you can choose a realistic budget, and you can decide whether you stick with that budget. The general rule of thumb is that it’s not wise for your mortgage to make up 28% or more of your gross pay. I think that’s pretty high, but many mortgage lenders will use that ratio (or something similar) to qualify a buyer. If you’re looking at houses that would require a mortgage payment that makes up, say 33% of your gross pay, you might be biting off more than you can chew.
Rules of thumb have limited use, though. What if you inherited a sizable amount of money, or you were the beneficiary of some life insurance proceeds? In that scenario, you might have low (or even no) income, but could still afford a mortgage payment in excess of 28% of your gross pay. Whether you’re approved for the mortgage is another story, but you might be able to afford the payment. Maybe the opposite is true for you, and 28% would be too high. Maybe you are anticipating a decrease in household income in the future, so you need to be looking at cheaper homes. Certainly, there are more scenarios that might apply to you that would make a rule of thumb less helpful.
Maintain A Goals-Based Mindset
Finally, consider the big picture. How does your home purchase fit with your other financial goals? If you take a large sum of money from your savings account for a down-payment so you don’t have to pay PMI, or so you can afford the monthly mortgage payment, what is the opportunity cost? In other words, are there better decisions you could be making with that chunk of savings? Would you still have an emergency fund? Some people even consider using their retirement savings to pay for a down-payment on their home. If you do that, are you still on track to meet your retirement goals? How much “catch-up” do you have to play with your retirement, and how does that compare to the savings on the mortgage? I could continue to list questions you need to consider. The bottom line is that you can’t consider these types of decisions in a vacuum; you need to think about your broader financial plan.
So, what happened with my friend? After talking her out of making a premature purchase, she continued to save for a down-payment….and mortgage rates continued to rise. In January 2018, the average 30-year fixed mortgage rate was 4.03%, and in November 2018 the average 30-year fixed mortgage rate was 4.87%. That was unfortunate. Then, rates turned around. The average mortgage rate has fallen every month between then and now, bottoming out at the aforementioned 3.77% in July 2019. If she chooses to buy now, her rate will be lower than when she initially contacted me, and her down-payment will be a year’s worth of saving more than it used to be. We don’t know what the future holds with interest rates, or with housing prices. But, if we keep a goals-based mindset and focus on what we can control, we can set ourselves up for a more positive experience.
Flagstone Financial Management is not a mortgage broker or real estate agent.