Housing Bubble, Plateau, or Mountain?
Lately, all I hear in the newscasts are remarks about the housing bubble. How the market can not sustain the current increase in values over time as it has been. Eventually, like the infamous Internet bubble, something will have to give and home values will bottom out. Are things really this drastic? I do not believe so, but people have set themselves up for a load of hurt using unsafe investment methods to afford housing during this radical increase of prices.
I have divided the theories into three segments:
+ Segment 1: The Bubble + Segment 2: The Plateau + Segment 3: The Mountain If you are betting your home on the Mountain theory, you are going to be in for a surprise. Either the Plateau or the Bubble are going to happen, and it is only a matter of time. Some markets are more primed for a bubble burst than others. For example, the Boston market, of which I am a condo owner in, is ripe for the burst. It is kind of like an apple left to rot on the tree, it can not sustain itself. According to this Boston Globe editorial, the median house price in Boston is $335,000. Nationwide, median housing prices have risen 20% from 2003 to 2005. Our salaries are not keeping pace. Salary increases in 2003, according to a 2002 salary.com article, were only projected to be around 3.4%. 2005 salary increases were projected (in December 2004) to most likely be 3.7%. This means, the average American salary was increasing at a substantially lower rate during the same time period.Banks have tried to “help” this process by offering risky loans. The ARM allows you to secure a low interest rate for 5 or 7 years at a fixed value, and then the rate adjusts according to the market. This is the least risky option, especially if you plan on selling your home in the 5 to 7 fixed rate period. The only problem is if there is a bubble, and it bursts, your home will lose value and make it unattractive to sell. You might find yourself stuck with an adjusting interest rate, which continues to rise. The interest rate has been steadily increasing in the last year.
The HELOC and HEL allow you take a loan based on the equity you have in your home. The HELOC carries adjustable rates while the HEL is often offered at a fixed interest rate. This means you are decreasing your current equity in a time where you could potentially need it if you were planning on selling. If you have any plans on selling your home, paying off two mortgages during a bubble burst could find yourself with no money towards a new home. Even in a plateau, this is dangerous as homes will cost more than you initially paid for, so you will find yourself lacking a down payment unless you have religiously saved.
Then, there are the interest-only mortgages. These are especially scary and there are more and more people taking advantage of them. The no-interest mortgage requires you pay ONLY the interest for a set period. Your equity in your home does not decrease as you make payments, but your initial payments are small. Over the course of the loan, you end up paying quite a bit more to the bank in interest payments as well. The banks love this loan. They get more money out of you and you are taking quite a bit more risk. The obvious risk being if the market bursts, you are stuck with a loan where you owe the entire value you paid, no equity, interest rates go up, and suddenly you can’t sell your property at anything close to what you paid for it. If you have to sell, you will end up owing the bank money a whole lot of money at closing.
A lot of these disaster scenarios can be avoided by buying prudently. If you can not afford right now, it might be better to wait a couple of years for the market to plateau or burst and get something then. Getting yourself into a situation where you are building no equity into your property defeats the entire purpose of owning and you might as well rent during the same period. There is also the dreaded maintenance. If all your money is going to the mortgage, you will not be able to afford the repairs necessary for basic maintenance on your property (current rule of thumb is 1% of your property’s value per year should be saved for maintenance needs). This could cause your home to lose value much quicker than any market bubble or plateau. Rents have not been increasing at the same rate as housing prices. You might find yourself in a better deal renting and letting someone else maintain the property.
Banks are realizing not everyone is thrilled with the idea of two mortgages, ARMs, or no-interest mortgages. They have begun to offer the 40-year mortgage. Like 15-year and 30-year fixed rate mortgages, these initially have a higher interest rate than ARMs, but your rate is fixed for the period. These are good choices and banks no longer require 20% down, or even 10% down. You can get a fixed rate mortgage with as little as 0% down if your credit is impeccable (and sometimes even when it is not), or even 3% down with decent credit. It pays to shop around.
To compare these mortgages, I went to bankrate.com and got the following rates for August 29, 2005 for the Boston area and used the median home price mentioned above with 3% down ($10,050) and 0 points:
10-year fixed: 4.75%
15-year fixed: 5%
20-year fixed: 5.125%
30-year fixed: 5.5%
The 40-year rate was not readily available so I’m estimating it based on the other numbers (I found one offering of 5.8% using a Google search, so I am probably not far off):
40-year fixed: 5.75%
3% down would require you borrow $324,950. Using the PMT function in Microsoft Excel, I determined the minimum payment for each based on these rates. Do not forget you also have property tax, PMI, and other costs on top of this number:
Monthly payments for:
10-year fixed: $3,407.03
15-year fixed: $2,569.68
20-year fixed: $2,167.03
30-year fixed: $1,845.03
40-year fixed: $1,731.62
The difference in payment between a 10 and 15-year loan is $837.34, a 20-year and 15-year loan is $402.66, a 30-year and 20-year loan is $322 and a 40-year versus 30-year loan is $113.41. The differences even indicate, unless you are on a very tight budget, the cost of a 40-year loan does not make much of huge dent and you do pay a lot more over the long run. I am keeping my money on the good, old 30-year loan for now. It might sound conservative, but I am not quite willing to bet my home on the mountain right now.
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