Did you know the median home price in Seattle is now $700,000? That is double the median price just 5 years ago! I recently read an article in the Seattle Times that said Seattle had the fastest rising home prices in the country for the 7th straight month. Wow!
That article got me thinking about the impact of rising home values. Read on to find out more about the upside, downside, and danger of rapidly rising home values.
Increased profit when selling
If you bought a house in Seattle 5 years ago for $350,000 and sold it this summer for $700,000, you would walk away having made a $350,000 profit. Home ownership is the main driver of wealth accumulation for American households.
Less likely to be underwater on mortgage
When home prices crashed in the Great Recession after the housing bubble burst, millions of Americans ended up underwater on their homes, meaning the amount they owed exceeded the value of the home. As of March 2012, four years after the market crash, approximately 11 million homeowners were still underwater. As home prices rise, people are less likely to be underwater.
For 60% of Americans, home equity makes up 67% of total net worth. If you own a home, rising home values mean you have greater home equity. This equity can become a source of cash when needed through a home equity line of credit or home equity loan.
When you purchase a home with less than a 20% down payment, you generally have to pay private mortgage insurance (PMI). If you pay down your mortgage to 80% of the purchase price you can have the PMI canceled – saving you the monthly fee. If your home value rises quickly, you may be able to have the PMI canceled based on the new home value.
First-time buyers feel the squeeze
As home prices increase, the amount needed for a home down payment also rises. Generally, 20% is a rule of thumb for a down payment. However, prices are moving faster than many people can save. In Seattle, a home that sold for $350,000 in 2012 (requiring a $70,000 down payment) would sell for around $700,000 in 2017 (requiring a whopping $140,000 down payment!). A family would have to save at least $1,167 per month just to keep up with the rise in the home price. First-time home buyer programs that have a reduced down payment requirement can help more people achieve home ownership by lessening the burden of the down payment.
Increased property taxes
As home values go up, so too do property taxes. Property taxes are only a fraction of the home value (around 1% – 1.5%), but for lower-income households and those on a fixed-income, the property tax increase can feel substantial. In Seattle, a home worth $350,000 would have a tax bill of roughly $3,500 per year (at a 1% tax rate). If the home value increases to $700,000, the tax bill increases to roughly $7,000 per year – that’s about $292 more per month. It may not sound like a lot, but for someone on a fixed income, that is a significant rise.
Increased ability and temptation to cash in on home equity
In the section on the upside, I discussed how homeowners have increased home equity with rising home values. This can be good if the homeowner is looking for a cheap way to finance a home repair or is looking to eventually sell their house. However, rising home equity can tempt many people to borrow against their home without considering the potential consequences. If home values fall, you may end up underwater on your home. This will limit your ability to sell or refinance. Also, be wary of using home equity to finance consumer purchases and vacations. If you run into any issues paying back your loan, your home is at risk. I urge people to be cautious when considering using a home equity loan to repay credit card debt for this reason. Credit card debt is unsecured – meaning that the debt is not tied to an asset. Examples of secured debt are mortgages, home equity loans, and car loans. For secured debt, if you do not make payments, you risk losing the asset. If you use a home equity loan to repay credit cards, and then become unable to make the payment on your home equity loan, your home is now at risk.
Using home equity to repay credit card debt or for other purposes is not always a bad idea, but be very, very cautious when considering this idea. It becomes less risky (but still a risk!) in the following situations:
- Your credit card debt is the result of a one-time situation such as a temporary job loss or serious injury/illness and not the result of an ongoing, chronic problem with debt or employment.
- Including the amount you plan to borrow, you will still have a relatively low loan-to-value (LTV) ratio for your home. For example, suppose your house is currently worth $250,000, your mortgage balance is $140,000, and you want to borrow $22,500. If you add your mortgage balance ($140,000) plus the home equity loan ($22,500), that brings the total debt on your home to $162,500 – exactly 65% of the value of your home. This is probably a relatively “safe” risk (but still a risk!) because it allows for your home to potentially drop in value 20% – 30% and still likely be able to sell and at least break even on the home debt in the event that you are no longer able to afford payments.
Home values do not always go up
As many learned the hard way after the real estate bubble burst in 2008, home values do not always go up. You can mitigate the risk of falling home values by paying as large a down payment as you can afford and avoid tapping into your home equity unless necessary. Be sure when selecting a home and a mortgage that you can comfortably make the payments. Homes can be a great forced savings plan and a source of long-term wealth that is valuable in retirement planning. However, homes come with risk and obligations for maintenance and repair. Within 5 years of purchasing my home, I will have paid for a furnace replacement and a new roof – two of the most expensive repairs faced by homeowners! Be sure there is room in your budget to make the both the mortgage payment (and insurance payment, HOA dues, if necessary, and taxes), as well as save for the inevitable home repairs and maintenance issues that will confront you when you least expect it.
Advice for First-Time Home Buyers
If you are looking to buy a home in an area with rapidly rising prices, you may want to consider buying sooner rather than later. With prices rising as fast (or faster) than you can save, it can be difficult to wait and break into the market later. HOWEVER, there is no guarantee that prices will continue to go up, or that prices will not fall back down after you buy. Trying to buy sooner may mean that you have a smaller down payment percentage, or that you buy at the peak of a market and end up underwater on your mortgage. The riskiness of this plan is mitigated somewhat if you are looking for a long-term home (10+ years). With a longer time horizon, you have more time to wait that will allow you to either pay off more of your mortgage or wait for home prices to rebound. Be sure to check out first-time home buyer programs in your area as there may be down payment assistance programs or specialized loans available. In Washington State, the Washington State Housing and Finance Commission has information on their website (http://wshfc.org/buyers/index.htm).