6 big answers for home buyers now that interest rates are soaring (The Washington Post)
What you need to know about refinancing later, tapping stocks or retirement accounts and how much house you can (really) afford to buy right now
The math on a 30-year, fixed-rate loan for a $600,000 house with a 10 percent down payment tells the tale: At a 4 percent interest rate, the monthly payment would be $2,500. At 7 percent, the payment is $1,100 higher, at $3,600.
“Every buyer needs to do a gut check” on how much house they can afford now, advises Patrick Holland, vice president at Embrace Home Loans in Fairfax, Va. So let’s get into some of the questions you may be asking yourself.
Do higher interest rates make it harder to qualify for a home loan?
In short, yes. Because higher interest rates mean your monthly mortgage payment will also be higher, the income required to qualify for a home loan goes up, too. When rates were 2.9 percent, for example, the average borrower needed an income of $133,450 to buy a $750,000 home with a 20 percent down payment, explains Hope Morgan, branch manager at Mortgage Network in Salisbury, Md. At a rate of 6.9 percent, that same loan would require an income of $195,700; the monthly payment would increase from $3,114 to $4,567.
Is it true that my housing payment should max out at 28 to 30 percent of my pretax income?
Financial experts frequently recommend keeping your housing payment within this range. But this is only a generalization. Depending on your personal circumstances, you may need to budget much less of your monthly income for housing to keep your finances under control. For instance, “you may have your kids in private school or have higher transportation costs,” says Isabel Barrow, director of financial planning for Edelman Financial Engines in Alexandria, Va. Barrow recommends breaking down your monthly expenses to truly determine how much you’ll need to stretch to afford the mortgage and whether you can cut down on discretionary spending.
At the end of the day, though, you’ll have to be honest with yourself: “If you now need $50,000 more in income to qualify for the house you thought you wanted, it may be that you need to find a less expensive house, wait for prices to come down, save more for a down payment or wait for a raise,” Barrow says.
How can I get a lower interest rate?
If you have extra cash, you can ask your lender to show you the difference in your monthly payment if you make a bigger down payment or pay extra to “buy down” the mortgage rate. Typically, “buying down” the rate involves paying a percentage of the mortgage balance (called a point) at closing to lower the mortgage rate for the life of the loan. One point is equal to 1 percent of the loan amount. The amount the rate will be lowered depends on the lender’s offer. Some lenders also offer to lower the rate for the first year or two for a smaller fee.
Before going this route, though, “it’s important to consider how long you’ll stay in the house, which helps you determine the break-even point when you’ll recoup [the extra cash you’ll have to spend] with the savings on your monthly payment,” Barrow says. “It may not be worth it if you’re in the house for just a few years.”
Adjustable-rate mortgages (ARMs) also tend to become a popular option when rates rise, because they offer a lower initial interest rate, but they carry significant risk. For example, your initial rate on a 7/1 ARM could be 5 percent for the first seven years, then adjust upward annually. ARMs typically have caps on how much rates can increase each year and over the life of the loan; those limits are often 2 percent annually and a maximum of 5 percent. So this loan could go as high as 10 percent. A homeowner who isn’t prepared for the adjustment might not be able to keep up with their payments and could lose their home. Many financial experts, including Barrow, caution against ARMs unless you are absolutely certain you’ll sell the property before the rate resets.
What are the penalties if I use money from my retirement account to buy a house?
It might be tempting to see the cash sitting in your 401(k) and decide to take an early withdrawal or borrow against it for your down payment. But this should be a last resort, says Momodou Bojang, a financial adviser and the CEO of Axiom Value in Rockville, Md.: “It’s best not to take money out of your retirement at all. You can borrow to buy a house, but you can’t borrow to fund your retirement.”
Plus, there are serious tax penalties to consider depending on whether you borrow from your 401(k) or take a withdrawal that you don’t intend to repay. “If you withdraw the money from your 401(k) rather than take a loan, you’ll pay a 10 percent penalty and income taxes on it at your regular income tax rate,” Barrow says. “This is a lose-lose situation, because if you’re borrowing because your home is hard to afford, you’re also going to have to work harder to save more to rebuild your retirement savings.”
Barrow says taking out a loan against your 401(k) is marginally better, because there’s no immediate penalty or tax consequences, but you’ll lose the long-term benefit of letting that money earn value while sitting untouched. In addition, if you don’t repay the loan quickly enough, or you lose or leave your job before it’s paid in full, you’ll be required to pay taxes and a penalty on the remaining loan balance.
The IRS has different rules for retirement funds held in an IRA account. “If you have an IRA, you can’t borrow from it, but you can take a withdrawal,” Bojang says. “You’ll pay a penalty and income taxes unless you’re older than 59½. First-time buyers get an exemption from the penalty.”
Should I cash in stocks to afford a house?
If you have non-retirement investment accounts, financial experts say tapping those to increase your down payment is preferable to eating into your retirement. But there are tax implications to selling stocks. “If you’ve owned the stocks for a long time and have a capital gain, you’ll pay a capital-gains tax” on the profit you’ve made on those stocks since first buying them, Bojang says. But he adds that the capital-gains tax will still probably be lower than the income tax you would pay on a withdrawal from a retirement account.
Still, no one is advising that you drain your savings and investments to get into a house. Indeed, once you become a homeowner, having cash on hand will be more important than ever. “You may need more cash reserves for an emergency when you own a house, because big expenses can crop up unexpectedly,” Barrow says. “We recommend keeping six months to two years of living expenses accessible.”
Can I refinance later when interest rates come down?
Some buyers assume that if they lock in today at a 7 percent interest rate, they’ll simply be able to refinance when mortgage rates eventually decline — but there’s no guarantee that mortgage rates will come down, or that home values will keep rising.
“If your mortgage payment is too high for comfort and inflation continues, you could end up having to sell your home … into a worse housing market” or wind up unable to refinance into a lower rate, Barrow says.
Refinancing also comes with upfront costs. Generally, you’ll have to come up with 1 to 1.5 percent of the new loan amount in closing costs when you refinance. Still, Morgan says, homeowners who are planning to live in the house for many years may want to refinance if rates drop by as little as one-half a percentage point, because this reduces the payment, especially on a large loan balance, and the interest savings over time can be significant.
** Sourced from The Washington Post