Buying a house in a housing boom seems like a dangerous economic move. On the other hand, your personal residence isn't simply an investment; there are many reasons for buying a house that have little to do with making money. Here are some thoughts on both sides of this interesting question, beginning with the characteristics of a housing boom and the housing bust that follows.
Economists have long known that financial markets are essentially cyclical. The housing market, among other things, is a financial market subject to the same cyclical forces. The cycle can fairly be described as having four quadrants.
The first quadrant is the recovery phase that follows the previous decline. During the recovery period, new construction is limited as market participants recover from their losses and struggle to regain confidence. However, populations continue to increase. Eventually the disparity between this relatively static housing supply and a growing population causes market tightening. Nevertheless, early in the the recovery phase rental properties are still widely available and there's plenty of houses waiting to be sold. Generally, the first indication that the housing market is tightening is that there's an observable decrease in the time houses and rental properties remain on the market.
The second quadrant is the expansionist phase, which is favorable to new enterprise. In response to increasing demand for a limited housing supply, housing prices begin to rise and builders resume building. Owners of rental properties begin raising rental rates. This puts more pressure on the housing market as renters faced with rising rents begin to buy houses instead. A side effect of the expansionist phase is that occupants of residential housing stay in their houses longer, further reducing the available supply.
The third quadrant, also an expansionist phase, may seem to be a continuation of the second. Prices still rise and new construction, if anything, accelerates as builders take advantage of generous capital markets to finance new, often ambitious building projects. Confidence and optimism are in the air. Few market participants seem to be aware that some of this confidence and optimism is excessive – that, to use former fed chief Allen Greenspan's memorable phrase, the housing market is in a state of "irrational exuberance." Rental housing vacancies are increasing, as does the average length of time a house remains unsold.
In the fourth quadrant, optimistic builders have not only replenished the supply of available housing and rental units; they've overbuilt. Occupancy falls, first slowly, then with gathering speed. Houses now remain unsold on the market for increasing lengths of time and are often eventually sold at sharply reduced prices. Building projects go unfinished as financing tightens. Eventually, the financial pressures on builders and developers lead to many bank repos, which then go on the market for less than the cost of construction. The fall in housing prices accelerates. Confidence finally collapses as the market capitulates to the crash.
This fourth recessionary quadrant in the housing market cycle can be especially brutal, for several reasons. Often, unhelpful fed policies are contributory. For instance, in response to an overheated boom economy, the fed may decide to raise interest rates late in the third phase. Mortgage rates increase in tandem, which increases the inability of buyers to qualify for available housing – already offered at premium prices in response to the housing market boom. This accelerates the growing discrepancy between an overbuilt housing supply and a population with decreasing financial ability to buy housing.
Another contributor to a housing market crash in the U.S. is the nature of residential financing, where buyers rarely put down more than 20 percent of the cost of a house and often put down five percent or less. Buyers, and certainly real estate agents, rarely consider the reality of such purchases, which is that they are buying with an extreme amount of leveraging, the acquisition of an asset with borrowed money.
In the stock market, the maximum amount of leveraging available for many years has substantially less. You buy $1,000 worth of stock with $500.00. This means that until the market value of your purchases declines by 50 percent, you still have an asset. Its value may have gone down substantially, but you still have an asset you can sell.
In the housing market, where 5:1 leveraging is the general rule, a 20 percent drop in the value of housing puts recent owners "under water," a phrase expressing the idea that the debt exceeds the total value of the purchase. They have nothing to sell and can only partially escape the consequences of the debt by declaring bankruptcy – or, like what happened in the housing crash of late 2007, where housing prices dropped by about a third from their peaks – simply by giving up and walking away from house with nothing.
It seems pretty clear that buying a house at the peak of a housing boom isn't a great idea. If you'd bought a house in 2007 with a 20 percent down payment, the crash would soon have left you with a house saddled with debt that exceeded its value.
So goes the conventional wisdom on the subject of when to buy a house. But there're are several flaws in this reasoning. The first among them is that no one can tell what the peak of the housing market may be until the peak has passed. In late 2017, more than half of the U.S. population believe a housing crash is either "likely" or "very likely." But that doesn't mean that the market will crash in 2018. It may or it may not. Often the conventional wisdom is wrong. The average cycle time from boom to bust is 18 years. This market has been booming for 6 years.
Another point is that if the 2017 housing boom continues long enough, even when the market crashes your house will still be worth more than you paid for it, possibly a lot more. The long-term average market gain in U.S. residential housing is about six percent each year. Like many long-term averages, this is a compounded return, meaning, that in the first year after you bought a house for $300,000, you'd gain six percent, or $18,000. But in the second year, you'd gain six percent of $318,000 and so on. Sometime during the 12th year, the house you paid $300,000 on would have doubled in value. If the market crashed at that point and you lost 30 percent of its value, your house would still be worth $120,000 more than you paid for it.
Another point still is that just as the housing market cycle includes the crash, so does it include the following recovery. Even in the 2007 crash, the second worst in U.S. history, if you'd stayed in that house you bought at the very peak of the market at the beginning of 2006 – and that had dropped in value by about a third in 2012 – by 2016, you'd have recovered everything you'd lost. And remember, so long as you're not selling the asset, it's only a paper loss to begin with. You bought the house for a certain price, hopefully with a fixed mortgage. Those mortgage payments continue without any increase and with nothing more out of your pocket meanwhile until you are fully recovered 10 years later.
According to Robert Schiller, who won a Nobel Prize in 2013 for his research and analysis primarily of the U.S. housing market, residential housing is not a particularly good investment. The stock market's average gain of more than nine percent is considerably better than the housing market's six percent gain, even before you take various expenses into account. On a house you pay annual taxes; while these vary from state to state, they're generally at least one percent of the house's value – sometimes much more. House owners frequently underestimate upkeep costs; the reality is they average from one to three percent of the purchase price every year. Also, there's insurance. When you put all these costs together, the probable annual net gain in a house from an investment perspective is probably no more than three percent, and more often less.
Another reality, however, is that most financial analysts don't think you should look at a house as an investment to begin with. In addition to being a residential property, it's your home. Most of the benefits of owning a home are very real, but not literally tangible: pride in ownership, feelings of security and well-being, and ability to control your housing costs without regard to booms and busts.
So, yes, if you're thinking about buying a house as an investment, and particularly if you're planning to cash out anytime soon, it's at best a mediocre idea. Late in a prolonged boom phase in a cyclical market, which is where we seem to be as 2018 rolls around, it might be a very bad idea. But if that house is your home and you plan to live in it for several years, buying it is a very good idea.
If you want to take out a mortgage loan backed by Fannie Mae, you'll need a solid credit score. The government-backed agency requires minimum FICO credit scores for both purchase and refinance mortgages. If your score isn't high enough, you might struggle to obtain a conventional mortgage loan originated by a private lender. Most private lenders prefer working with borrowers who generally have high credit scores.
Lenders rely on your FICO credit score to help determine how likely you are to pay back your mortgage loan on time. The score tells lenders how well you've managed your credit in the past. If your score is low, it means that you've missed payments, paid bills late, or have high credit-card debt. Most lenders reserve their lowest interest rates for those borrowers with FICO scores of 740 or higher.
Your loan-to-value ratio plays an important role in Fannie Mae's minimum requirements. The lower this ratio -- meaning that your mortgage loan amount is equal to a smaller amount of your home's value -- the lower your FICO score can be to qualify for a Fannie Mae-guaranteed home loan. If you're taking out a mortgage loan to purchase a principal residence or to refinance a principal residence, you'll need a FICO score of at least 620 to qualify for a Fannie Mae-guaranteed home loan, but your loan-to-value ratio must be less than 75 percent. If your loan-to-value ratio is greater than 75 percent, you'll need a minimum FICO score of at least 680.
These requirements change, though, if your monthly debts eat up too much of your gross monthly income. If your debts take up 45 percent or more of your gross monthly income, you'll need a credit score of at least 700 to qualify for a Fannie Mae-guaranteed loan if your loan-to-value ratio is greater than 75 percent. You'll need a score of at least 640 if your debt-to-income ratio is equal to or greater than 45 percent, and your loan-to-value ratio is less than 75 percent.
Fannie Mae's credit-score requirements are more stringent when it comes to second homes. If you need a mortgage loan to purchase a second home or you want to refinance a mortgage on a second home that you already own, you'll need a minimum FICO credit score of 660 if your loan-to-value ratio is less than 75 percent. If this ratio is more than 75 percent, you'll need a minimum credit score of 680. If your debt-to-income ratio is 45 percent or higher, you'll need a minimum FICO score of 700 if your loan-to-value ratio is greater than 75 percent, and 680 if it's under that mark.
Your debt-to-equity ratio is an important number. It tells you whether you can qualify for a traditional refinance or if you've built up enough equity to take out a home equity loan or line of credit. Ideally, the equity in your home will steadily grow after you purchase it -- but that might not happen if your home's value has fallen since you purchased it.
Your debt-to-equity ratio measures the relationship between how much you owe on your mortgage loan and your home's value. If your home is valued at $250,000 and you owe $180,000 on your mortgage loan, your equity stands at $70,000. You calculate your debt-to-equity ratio by dividing your debt into your home's current value. In this case, $180,000 divided into $250,000 comes out to 72 percent. This means that your debt-to-equity ratio stands at 72/28. Your debt is equal to 72 percent of your home's market value.
Real estate appraisers play an important role in figuring your debt-to-equity ratio. When you apply for a home equity loan or home equity line of credit, or when you apply for a refinance of your existing loan, your lender will send an appraiser to your home to determine its current market value. The appraiser will do this by touring your home, checking for updates and analyzing the sales of similar homes in your neighborhood. Once the appraiser determines the home's market value, and you know how much you owe on your mortgage loan, you can determine your debt-to-equity ratio.
You'll need to know your debt-to-equity ratio when applying for a refinance. That's because most lenders won't approve you for a refinance unless you have a debt-to-equity ratio of at least 80/20, meaning that you have at least 20 percent equity built up in your home. There are options for refinancing if your debt-to-equity ratio is higher than 80/20. The government, for example, offers its Home Affordable Refinance Program for those homeowners who have little or negative equity. A standard refinance, though, is usually a less complicated process.
You'll need to know your debt-to-equity ratio if you'd like to borrow against your equity through either a home equity loan or home equity line of credit. A home equity loan is a second mortgage, while a home equity line of credit acts more like a credit card. These two products allow you to tap into your home's equity and then use that money to pay down credit cards with high interest rates, fund a major home improvement, pay for a child's college education or cover any other cost you'd like. Lenders, though, will provide you with a home equity line of credit or home equity loan only up to a percentage of your equity. If you have equity of $80,000, your lender might only allow you borrow up to $60,000.
Property frontage is the outward appearance or “curb appeal” of your home or land. This first impression is what a potential buyer will remember; think of it as the formal introduction to your property. The exterior's condition, as well as landscaping and yard maintenance all play key roles. Many potential home buyers will rule a property off their lists based simply on curb appeal, so it is imperative that you do everything possible to enhance that first look. It's a sure way to attract the greatest number of interested buyers--and to fetch the highest price--for your property.
The property value of a neighborhood is determined by what buyers are willing to pay to live in that area. So, while the frontage of your home helps establish its value, surrounding houses also play a part. A property could be immaculate with excellent landscaping and lawn care, but the value would be hurt if it sits next to a run-down house with a yard full of weeds. When making an offer for a house, most buyers consider how much it would cost to fix problems; but they also might lower their offered price because of unattractive surrounding properties.
Many neighborhoods have homeowner associations that enforce rules to ensure a uniform appearance--good curb appeal--for properties in the area. But you can take some simple steps to improve your own property frontage and increase the overall value of your neighborhood, too.
According to Homegain.com, doing things like painting, adding landscaping and cleaning driveways can have a substantial, positive effect on the value of a property. Painting your home's exterior--a typical $1,800 investment--can increase your sales prices by as much as $10,000. Landscaping can add another $5,000 and could be something as simple as planting a tree, putting in some shrubs and sprinkling fresh mulch in flower beds. Pressure washing a driveway may seem like a small thing but it, too, can go a long way toward boosting curb appeal.
Appraising a home's value is far from an exact science. Real estate appraisers consider several factors when trying to determine how much your home is worth. Your home's location and neighborhood play a role. Generally speaking, if your home sits on a busy street, it's appraised value will be lower than if it sat along a quiet side street. But other factors might outweigh the negative impact of a street choked with traffic.
The appraiser's job is to consider several factors to determine how much a home is worth. Lenders hire appraisers to make sure that their buyer clients aren't spending too much to purchase a home. They also hire appraisers when their clients want to refinance an existing mortgage loan. Most lenders require that homeowners have at least 20 percent equity in their homes before they'll grant them a refinance. To determine equity, lenders must first know how much a home is worth.
Appraisers will usually penalize a home for sitting on a busy road. That's because fewer buyers typically want to purchase a home that is so close to traffic. This reduces the demand for a particular home and also reduces the price that people are willing to pay for it. The home's location -- in this case, alongside a busy road -- is just one factor that an appraiser considers when setting a market value for a home. But it is an important one.
Appraisers will consider the improvements that homeowners made to their residences -- such as the addition of a master bedroom suite or a kitchen gut renovation -- when determining how much a home is worth. They'll also consider the condition of a home. If homes show obvious signs of neglect, such as peeling paint or appliances that no longer work, appraisers will ding a home's value. Appraisers consider, too, the sales prices that other homes in the area have fetched. If a home scores well on all these additional factors, it might still appraise at a high value even if it does sit on busy road.
Homeowners can't change the fact that their residence sits next to a busy road. They can take steps, though, to make sure their home is well-maintained and updated. Homeowners can boost their home's appraised value by repairing cracked driveways, patching leaking roofs and repairing broken dishwashers. They can fix windows that no longer open, replace torn carpeting, and repaint peeling kitchen and living-room walls. Those owners who want to further improve their home's value can invest in the improvements that make residences attractive to buyers. This can include new kitchen cabinets, the addition of a master bathroom and new stainless steel appliances.
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