Worried about the real estate market crashing? This will help

We are living in the first tough economy since the Great Recession. Naturally there are people that worry about the real estate market crashing again. The memory of half the houses on any street being for sale and owing more on your house than it is worth is all too fresh.

While I don’t see any need to be concerned about that happening again, I got to thinking about what that would look like if it were to happen.

Let’s look at a huge difference between 2005 and today. Both are times when the real estate market was on fire.

Back in 2005, the interest rates I was seeing were around 5.5%. The market was good. Values were high. Then when the 2006 season kicked off, it wasn’t as good. The following years until 2012 got worse and worse. Fewer buyers. More sellers. More foreclosures. Unlike stocks, real estate values usually rise gradually and fall even more gradually. Short of a landfill being built behind your house, you are not going to wake up one day and find your house is worth 20% less than it was the day prior. Remember this because I will bring it up later.

That person who paid $300k for a house in 2005. Let’s say they did a 30 year mortgage at 5.5%. One year into their mortgage, they owed about $296k still. After five years, they still owed about $277,500. This is why many of them had to BRING money to a closing when they needed to move in 2010. Back then, one of the first things you would ask a potential seller was “How much do you owe on it?” Many were upside down on their houses, which is why many chose to walk away and let the house get foreclosed.

Today, a buyer can get a 2.875% interest rate for the same $300k house. That is just over half what it was 15 years ago. After one year, they owe about $293,500. After five years, they owe around $266k.

Okay, now it’s time to remember I said real estate values, when they drop, don’t drop fast. It took about 5 years for values in the Lexington area to drop about 15% from the 2005 peak values. Some houses didn’t even loose that much. Picking a good house with a good floor plan, on a good lot, in a desirable neighborhood for the price range and with average or better performing schools is the best way to protect yourself from a bad market. If you look at the math on today’s buyer getting a super low interest rate, you will see that in five years, they have paid off about 12% of their balance. If they get a couple years of appreciation before a decline, the numbers are even better!

I know I got a little nerdy there with the math. Sorry. In the end, my point is that should the market crash again, today’s buyer is going to be in much much much better shape due to low interest rates. If the value of your house drops at the same rate that you are paying down your mortgage, then the worst thing that can happen is you just aren’t building equity in the house. It’s effectively like you’ve been renting where you pay to live there and walk away with nothing when you sell…..and this is the worst case scenario. The best case scenario is that the market stays good and you build a ton of equity. I just don’t see much risk in buying a house right now thanks to low rates.

Low interest rates could be the WORST thing to happen to the market

Yep. I know. It doesn’t make sense at first. How could these incredibly low interest rates possibly be a bad thing? They are a very good thing right now for people buying or refinancing their existing house. The problem is in the future.

Let’s take the average person who has probably refinanced their old mortgage recently. Let’s say they paid $160k for their 1700 square foot home in Masterson Station in 2013. They put 5% down on a conventional loan. Their interest rate was 3.875%, which seemed stupid low at the time since rates had been about 5% just a few years earlier. Their payment, excluding taxes, insurance and PMI, would have been about $714 a month. They decide they want to refi. Their house is now worth about $210k. They owe about $126k on their old mortgage. They get a 3% interest rate and now their payment is about $531. They are saving around $180 per month. They are happy.

Now lets look 5 years out from now. They want to move up to a $300k house. (Let’s keep the value of their current house and the one they want to buy based on today’s values since both should appreciate about the same….it just makes it easier for me to do the math!) They have close to $100k in equity, so they are effectively only going to finance an amount that is about equal to the value of their current house. This is really sounding good. But wait, maybe the interest rates are 5%? If so, their payment will more than double. That’s right. They have close to $100k down and are borrowing an amount equal to the current value of their existing home. Their new payment for principal and interest would be just over $1100 a month. People who need mortgages shop by their mortgage payment. They find out what they can afford per month and then figure out how much house it buys. These people won’t move. They will upgrade their existing house instead.

The same holds true for the people buying a house today. They won’t want to see their mortgage payment double if interest rates go up, so they will stay as long as they can stand it.

This is why, unless interest rates stay very low for a very long time, eventually there will be even fewer houses for sale. This will of course keep prices high since there will be less of a supply and demand will not decrease. We are not building enough new houses and the next generation of buyers will be bigger than previous generations.

So, what’s the take away here? If you can see yourself staying in your current house for 7-10 years, refi now. If you are a buyer, buy a house big enough to stay in for a long time. The last thing you want to do is outgrow your current house in 3-5 years and possibly not be able to afford a larger one.

When will there be more houses for sale?

The simplest answer to this is when sellers feel like moving…..so I guess it boils down to what will it take for that to happen?

Many people who have been in their houses for more than 5 years either got a super low interest rate or refinanced to get one.  It is hard to give up something like a 3.5% rate and buy your next house at the top of the market and do a 5% mortgage.  Right now, all that free equity from appreciation isn’t enough to make somebody want to give that up.

But, eventually there will be a tipping point.

Let’s say you bought a house 5 years ago for $200k.  You put down 5% and got a 3.5% rate for 30 years.  The principal and interest part of your loan is about $900 a month.  Flash forward to today.  The house is probably worth $240k.    You owe about $173k on it and have about $67k in equity.

You decide you want to buy a $300k house.  You finance about $235k after you get the equity out of your last house.  You get a 5% rate.  The principal and interest part of your loan is now $1200 a month.

Maybe you don’t want to spend $300 more each month?

What will it take to make you list your old house?

Maybe another $40k equity in your old house?  Assuming rates stay about the same and the price of the $300k house you want appreciates less than the $240k house you have, this $40k is what it will take to keep your payment about the same each month.  It will take about 3 years for that to happen between appreciation and what you are paying down each month in principal.

We all bemoan higher interest rates, but lets keep in mind that the reason we don’t like higher rates is because they make the mortgage payments higher.  People have a certain amount they can/will spend each month on housing.  People will always try to stuff as much house into that payment as they can.  I think the day sellers can move up to a nicer house and not pay that much more will be when we see more for sale signs in yards.