The Chill In The Housing Market Might Have You Wondering If It’s Time To Buy

Interest rates are at 20-year highs across several advanced economies and some fiercely competitive real-estate markets have finally started to soften. And that might have you thinking that now is the time to buy. Owning your home is attractive for many reasons, but it might not always be the best option for your money. Here’s how I would think through my decision:

How much can you afford to put down?

Falling home prices are great if you’re going property shopping, but in this higher interest rate environment, cash buyers stand to benefit the most. That’s because they won’t feel the sting of those higher borrowing costs. No matter what the mortgage rate, the more you can put down on a home, the less you’ll pay in interest. But the incentive to pay more toward the overall purchase price is greater when interest rates are higher, as they are now.

If you’re waiting for house prices to fall a lot more before you buy, you could be disappointed. The theory is that higher mortgage costs will put off potential buyers, shrinking housing demand, and eventually causing house prices to fall. And in places outside of the US – where fixed rates can’t be locked in for the duration of a loan, but instead expire after just two or five years – the theory is that homeowners will be forced to sell their houses when it’s time to refinance at higher interest rates, flooding the market with excess inventory.

The countries that are most exposed to a housing market slowdown. Source: The Economist Intelligence Unit.

While downward pressure on home prices can already be felt in some markets, like in the UK or eurozone, it can take a long time for prices to fall low enough to make up for the additional per-month cost that comes along with higher interest payments. And that kind of fall might never happen: there are plenty of reasons why home prices could actually hold up.

How much would prices have to fall to make up for the higher mortgage costs?

Unfortunately, not everyone can afford to buy their homes with a suitcase full of cash. For more common folk like me, there’s a tradeoff between lower home prices and higher interest payments that’s worth understanding.

In the US, mortgage lock-in periods are longer, so you can get a 30-year fixed-rate mortgage right now at about 7%, which is more than double the 3.3% average seen from 2019 to 2021. And if rates go down during your 30-year period, you could refinance at the lower rate. In other words, US homeowners face a lot less interest rate risk compared to homeowners elsewhere.

But mortgage lock-in periods are a lot shorter in other places. A borrower in the UK, for example, can generally nail down a set rate for just two or five years, and that exposes them to a lot more interest rate risk. Here’s a look at why…

For the sake of simplicity, I’ll start with an illustration of a 30-year fixed mortgage whose rate expires after two years.

Imagine you have $50,000 in cash, enough for a 20% deposit on a home worth $250,000. That means you’ll have to borrow $200,000.

At the current 7.0% rate, you’ll pay $14,000 in annual interest. (7.0% x $200,000)

At the historical 3.3% rate, you’d have paid $6,000 in annual interest. (3.3% x $200,000)

Over two years, you’ll end up paying $16,000 more in interest to the bank at the higher rate. (2 x ($14,000 - $6,000))

If you expect mortgage rates to normalize over time, back to the lows seen pre-Covid, then you should expect home prices to fall at least 6.4 percentage points in order to justify paying higher interest over the next two years. ($16,000 ÷ $250,000)

In simple terms, you’ll need to expect a pretty sharp fall in house prices. And that might be pretty unlikely: UK home prices have rarely fallen more than 1.5% in any given year. The steepest fall was 8.5% in 2009, in the throes of the global financial crisis. The US saw a similar drop at the time, with prices troughing 10%.

Annual percentage change of property prices in the UK. Source: UK House Price Index.

Source: Black Knight US Home Price Index (HPI). Percentage change of property prices in the US.

How much can you afford to pay in rent versus mortgage payments?

Depending on where you live, it can sometimes make more sense to rent than to buy.

According to Realtor.com, across the 50 biggest metro areas in the US, a typical renter pays about 40% less per month than a first-time homeowner.

But by paying a mortgage, you’re “paying yourself” and building your equity, rather than building your landlord’s equity. And you won’t have to worry about potential rental rate increases. That said, owning a home can come with a lot of extra costs on top of your monthly payments, including repairs and maintenance.

Going back to our first example, at 7% interest, you’ll be looking to pay at least $1,561 a month over 30 years, after a 20% down payment on a $250,000 home. A mortgage calculator can help you customize these numbers.

What are the opportunity costs of making a big down payment?

Opportunity costs aren’t something prospective homeowners often consider, but they probably should. In simple terms, they measure the costs of choosing one option over another.

In the case of purchasing a home, the biggest opportunity cost is the returns that might have been gained from investing it elsewhere. The higher the interest rates, the more sizable your opportunity cost.

Based on current market rates, you could get 6.1% on a two-year fixed deposit:

First year: 6.1% x $50,000 = $3,050

Second year: 6.1% x $53,050 = $3,236

Total: $3,050 + $3,236 = $6,286

That would work out to be $6,286 foregone over the same period if you had put the cash toward a home purchase instead. This cost would be much higher if you had invested in stocks instead. Though these returns aren’t a sure thing: the average annual return of the S&P 500 (as measured over ten-year periods for better accuracy) is almost 12.5% over the past decade, implying opportunity costs of $13,281.

Of course, if your home price goes up, that will offset these costs in the long run. And those gains might be substantial considering the leverage (your loan-to-home-value ratio) you have on your home. Leverage magnifies your gains and losses on either side.

Buying a home may not feel like an investment, but it’ll likely be your biggest purchase and asset so it shouldn’t be a rash decision. Make sure to weigh your options carefully, just like you would with any other investment.

What does homeownership mean to you?

Ultimately, there’s always a limit to financial advice. Buying a home can be purely a financial decision for some, but to others, it’s more like the realization of a dream. If that’s you, then it’s good to acknowledge that non-quantitative factors probably play a bigger part in your decision.

The qualitative benefits of owning your home outright are in the freedom and security they give you. You’ll likely have fewer worries about finding a stable accommodation and will have a store of value you can draw on, for whatever life throws at you.

What if buying where you live is still out of reach?

That’s certainly relatable for a lot of people in places like San Francisco, New York, London, and Toronto. Depending on the real estate prices where you live, and your income and savings levels, buying a place might not be realistic right now. But if properties appeal to you as an asset class, there are countless other ways to invest. For example, you can invest in the real estate market through real estate investment trusts (REITs), or indirectly through listed developers and homebuilders.