We work with many young couples and growing families, and decisions around housing are a huge factor in someone’s long term financial plan. With rising interest rates and housing prices barely budging, we hear many people asking versions of these questions frequently:
- Should we rent or own?
- Is now the right time to buy?
- If my family has grown but we’re locked into a 3% mortgage, how do we justify moving?
- What are appropriate investments if we’re saving to buy a house?
- Do we have to put 20% down?
With all of these questions, like most things in “personal” finance, the answer is personal. The important thing though is to put a plan in place before making a major and expensive financial decision. For most people, their monthly housing payment, whether a mortgage or rent payment, is their single biggest monthly expense.
Unfortunately, many personal finance blogs spend all their time beating up on Starbucks $5 lattes, but spend very little time educating people about big decisions like housing.
Before we tackle some general principles about these big housing questions, I think it’s important to look back and see how we have arrived at the current state of the housing market today.
THE ORIGINS OF THE HOUSING SHORTAGE
The United States has been grappling with a significant shortage of single-family housing since the aftermath of the 2008 financial crisis. This shortage has contributed to rising home prices, decreased affordability, and increased competition among potential homebuyers. Below we look at some of the complex web of factors that have led to the single-family housing shortage, examining the lingering effects of the financial crisis, demographic shifts, regulatory constraints, and other key drivers.
Lingering Effects of the Financial Crisis
The 2008 financial crisis dealt a severe blow to the housing market in the United States. Widespread foreclosures, plummeting home values, and tightened lending standards left scars that continue to affect the market today. Many homeowners lost their properties to foreclosure or entered into short sales, resulting in a significant reduction in the supply of single-family homes.
Following the financial crisis, the construction of new single-family homes lagged behind historical levels. Builders faced numerous challenges, including limited access to credit, volatile construction material prices, and a shortage of skilled labor. Additionally, stricter lending standards and increased regulatory scrutiny made it harder for builders to secure financing for new projects. The market went from oversupplied before the financial crisis to undersupplied in a short amount of time and we’ve haven’t caught up since.
Land Use Regulations and Zoning Restrictions
Land use regulations and zoning restrictions have also contributed to the single-family housing shortage in the United States. Many local governments impose stringent zoning laws that restrict the development of single-family homes, favoring higher-density housing or commercial development instead. These regulations can limit the availability of land for new home construction and drive up the cost of development, making it less economically viable for builders to construct single-family homes.
Demographic Shifts and Changing Preferences
Demographic shifts and changing preferences have further exacerbated the single-family housing shortage. Millennials, the largest generational cohort in the United States, are reaching prime home buying age, driving up demand for single-family homes. Additionally, the COVID-19 pandemic accelerated remote work trends, prompting many individuals and families to seek larger homes with dedicated office space and outdoor amenities, further fueling demand for single-family housing.
Affordability Challenges
Rising home prices and slow wage growth have made homeownership increasingly unaffordable for many Americans. The shortage of single-family housing has contributed to bidding wars, driving up prices and pricing out potential homebuyers, particularly first-time buyers and lower-income households. The rapid increase in mortgage rates has only modestly slowed the rise in housing prices, and continues to frustrate would-be buyers who are hopeful for a pull back. Additionally, the lack of affordable housing options has forced many individuals and families to rent, further exacerbating rental affordability challenges
Investor Activity and Short-Term Rentals
Investor activity and the rise of short-term rentals have also played a role in the single-family housing shortage. In recent years, institutional investors, foreign investors and private equity firms have entered the housing market in search of rental properties, driving up home prices and reducing the supply of available homes for owner-occupants. Additionally, the proliferation of short-term rental platforms like Airbnb has led to the conversion of single-family homes into vacation rentals, further reducing the supply of homes for long-term residents.
What does all this mean for those important housing questions?
As you can see, the single-family housing shortage in the United States is a multifaceted issue with roots in the aftermath of the 2008 financial crisis and exacerbated by a combination of factors. Unfortunately, it looks like there is not going to be a short term solution to this problem. For those who are waiting on the sidelines for a pullback in prices, it’s possible given all these factors they could be waiting for years for the supply of new housing to increase and prices to decline.
Our advice remains unchanged when it comes to housing. You should make the decision around housing based on your personal financial situation and long term objectives of your plan. That decision should align with a housing option that fits comfortably into your monthly budget. Some of the greatest financial stress I see among young people is taking on too large of a housing payment, and then feeling “house poor” once they are stuck with the payment. It’s important to analyze and think about these questions as part of a broader financial plan BEFORE making a huge decision and not after!
While this decision is personal, here are some general rules of thumb related to these questions as a starting point in the process.
If buying versus renting a house will you plan to stay there for at least five years? This is a typical rule of thumb for the amount of time it will take to recoup the closing costs but can vary widely depending on how home prices change in the area. Our first house we ended up selling after three and a half years. We were lucky prices moved favorably and just about broke even over that time.
How does the overall payment fit into your financial plan? A general rule of thumb is to not have your mortgage payment or rent payment exceed 28% of your gross monthly income and not to have your total debt payments from all sources exceed 36%. Again, these are rules of thumb and your housing payment should be looked at individually based on your financial plan. We personally purchased our current house for far less than we were approved for because we knew my wife planned to stay home and our income was going to drop. If you are buying a house, you also have to think about ancillary expenses and maintenance costs that you wouldn’t pay as a tenant normally while renting. We typically suggest to budget at least 1-2% of the home value annually for these ongoing expenses as a starting point, but this can vary significantly depending on the age and condition of the home
How do we justify moving if we’re locked into a low mortgage payment? This is a difficult decision but comes down to the affordability of the new payment. Chances are if you’ve been locked into a low mortgage rate for a while you’ve also built significant equity in your home over that time, as housing prices in most areas have shot up substantially in the last few years since COVID. Although you will likely end up with a much higher interest rate on a new mortgage, you may be able to keep the payment to a reasonable level by putting a larger down payment on the new property from the equity in your current home. Capital gains taxes are excluded up to $250k for an individual and $500k for a couple as long as the home has been used as a primary residence for at least two of the last five years. It’s not guaranteed, but the federal reserve is signaling they may begin cutting interest rates again towards the back half of 2024. This means that the opportunity to refinance to a lower mortgage rate could present itself in the near term future.
What should we invest in to save for a down payment? This will depend on your time horizon for the home purchase. We generally suggest anything less than five years should be put into a short term cash or fixed income instrument and not exposed to the fluctuations of the stock market. This might vary depending on someone’s individual risk profile, or how locked in they are to a specific timeline for purchasing a home. For longer than five years, a less risk averse investor might consider owning more stocks inside of a taxable brokerage account to prepare for a down payment. There are also certain rules applicable to IRAs/Roth IRAs, allowing first time home buyers to access a portion of those account balances.
Do we have to put 20% down? No, there are loan types available that allow you to put lower down payments. Although a lower down payment, will typically result in paying an additional cost of Private Mortgage Insurance (PMI). It’s important to see how a lower down payment would increase the cost of the monthly payment and ensure it still fits comfortably within your budget. A lot of millennials also carry private student loans which may make sense to pay down, especially if they make too much to qualify for the student loan interest deduction but can take the extra mortgage interest as an itemized deduction. Your credit score will also impact your mortgage rate and ability to qualify for certain loans.
SUMMARY
Buying a home is a big and expensive decision and one that should not be taken lightly in a financial plan. We can’t stress enough the importance of running the numbers and aligning the decisions with your goals before moving forward. Oftentimes there are a multitude of factors outside of the monthly payment and down payment to consider, such as tax considerations. It is wise to consult with a financial planner to evaluate how your housing goal fits into your overall financial plan.
