Personal Finance > Your Home

Tips for buying a home
Is now the right time to buy? Does a second home pay? And is an ARM better than a fixed?
November 19, 2002: 12:23 PM EST

NEW YORK (Money Magazine) - It may define the American dream, but buying a home remains one of life's biggest sources of stress. From choosing a loan to paying for closing costs, it's enough to put even the most mild-mannered among us on edge.

That goes double in today's red hot real estate market, where would-be buyers are scrambling to determine how much house they can afford, whether second homes are a wise investment and if now is the right time to jump in at all. Others, too, fear the market may be ready to tank in their neck of the woods. Bargain basement interest rate also complicate the equation. Do adjustable rate mortgages still make sense?

We've got the answers to all your questions right here:

1.) Am I nuts to buy a home in this real estate market?

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It's easy to look at the woes of the stock market and conclude that residential real estate will be the next economic domino to fall. But such thinking ignores some obvious differences between stocks and homes. High transaction costs (agent fees, mortgages, title searches and other mystery services) create big barriers to speculating in the housing market. And since homes provide living quarters for their owners, there's little likelihood of panic selling. The upshot is that residential real estate is virtually bubbleproof. Average home prices have yet to post a year-over-year decline in the 30 years the federal government has been tracking them and, according to Freddie Mac chief economist Frank Nothaft, the last significant decline in average U.S. home prices occurred during the deflationary era of the Great Depression.

While we wouldn't rule out declines in some overheated markets, we don't think you're nuts to be buying. In fact, postponing a purchase is more likely to cost you money than save you money. Regional crashes--Houston in the late 1980s, Boston in the early '90s--have been so few and far between that the odds of a home buyer successfully timing the market are incredibly long. Historically, home prices rise steadily even in areas with declining populations and sputtering economies: In Buffalo, for instance, median prices have nearly doubled since 1984, and in 1999, the single worst year for Buffalo real estate, median prices declined by all of 3 percent.

Moreover, the correlation between stock prices and real estate isn't as strong as many believe. Recent gains in U.S. housing prices--6.5 percent over the past year alone--are a fraction of those achieved by stocks at the height of the bubble. Not only that, the single best real estate market of the past 30 years occurred when stock prices were trending lower. In the late 1970s, home prices rose at annual rates as high as 15 percent, notes Lyle Gramley, a former Federal Reserve governor who's now an analyst for Schwab Washington Research. Even after controlling for inflation, home prices were rising faster than they are today. And in the years following the '70s boom, prices continued to climb at a modest rate, even as housing starts plunged 50 percent.

The fundamentals of housing are also much healthier than those of pre-crash stocks. At the height of the tech bubble, the Nasdaq composite traded at an amazing 145 times earnings--10 times what was probably appropriate. In a real housing bubble, you'd expect to see comparable signs of excess in the form of speculative home building and a glut of new inventory. Today, however, the inventory of unsold homes is unusually low--4.5 months' worth of supply vs. a 20-year average of 7.5 months.

The point is, if you're ready to buy a home, there's no time like the present.

2.) Will any major real estate markets see values drop in the coming year?

In mid-October, noted economists Karl Case and Robert Shiller--partners in the real estate analysis firm Case Shiller Weiss--sat down with MONEY in their Cambridge, Mass. offices to share some big-picture insights about the current home market. First they offered some good news: though they see appreciation rates slowing from last year's double-digit growth, most major markets should post respectable gains, especially in the low- and mid-price ranges where demand remains strongest. Among the most robust metro areas, they single out Miami (a result of population growth and immigration) and Washington (population growth and federal defense spending). The weakest? San Jose, where a hyperinflated market is getting battered by the loss of technology jobs.

Both men, as it happens, have been astonished by the strength of the housing market this past year. In October 2001, when MONEY checked in with them in the wake of Sept. 11, Case and Shiller wondered whether the terrorist attacks signified a drastic "turning point" that would prove damaging for both urban economies in general and the U.S. economy overall. Though such a reversal never came to pass, they continue to believe that the home market is fraught with risk. When talk turns to the prospect of a bubble, the duo acknowledge some sobering possibilities. "We are more vulnerable to a national housing bust than ever before," Shiller declares. That does not mean he thinks it will happen. But the speculative quality infecting parts of the housing market recently--the urgency to buy now or get left behind--suggests a degree of irrational exuberance he last observed during the '90s Nasdaq run-up. And that could end badly. Case also entertains some dire possibilities, yet he seems to weigh in against them more forcefully than does his partner. "There's a bigger probability of a nasty free fall for a while than there's ever been," he agrees. "But I don't think that's going to happen, meaning I'd bet even odds against it."

Part of Case's reasoning is grounded in his belief that fundamentals like income growth and interest rates justify the strength of the home market in the late 1990s. "I'm not arguing there's no speculation now," he adds, "but somehow my gut tells me it's not as crazy as the Nasdaq at all, and there are at least some variables you can point to that make the home market more rational than it would otherwise seem." Furthermore, like Shiller, Case believes that the events of Sept. 11 help explain why real estate (a more psychologically and physically secure place to park your money) has been the investment of choice over the past year, not only in this country but throughout most of Europe and Asia, which are also enjoying a widespread housing boom.

In any event, whether the home market is now on a high mesa or is about to slope downward--an event that seems already discernible in luxury housing around Boston and San Francisco--it's helpful to remember that we won't experience the kind of stomach-clenching drops we see in the stock market. By its very nature the home market deflates over many months or years, Case says, unlike a technology stock or a corrupt scheme like Enron. And in some unwaveringly strong markets, like Chicago or Phoenix, valuation rates have historically slowed without any discernible drop.

Does that mean a buyer or owner shouldn't worry about appreciation or about a speculative episode? "Sure you worry," says Case. "You're buying something with leverage, which multiplies the returns on the upside and the downside. Worrying about its value is rational." But Case adds that by his calculations, owning a house (as opposed to renting one) offers the home buyer a 7 percent return in what he terms "housing services." And it provides a host of tax advantages. And it's a durable good. And your money is sunk into a place where you can actually grill a hamburger and relax.

3.) Is this a good time to buy a vacation home?

As with primary residences, the odds are stacked against anyone trying to time the vacation-home market, which is why now is as good a time to buy as any. Massachusetts agent Paul Grover notes that in the 22 years he's been selling vacation homes in Cape Cod, there was only one brief stretch when average prices actually declined: "It was in the early 1990s, and it was only by 5 percent or 10 percent."

We understand why some people are convinced that the rapidly rising second-home market is due for a fall. Beach houses, ski chalets and country retreats are perceived as luxury goods, and the market for luxury goods is notoriously cyclical. But what makes vacation homes different from, say, a Mercedes or a Rolex is the fact that real estate is also an investment. And even though the stock market's collapse has left consumers with far less money to spend on luxuries, demand for vacation homes has held up because those same investors are allocating more of their net worth to real estate. Over the past five years, prices in high-end markets like Cape Cod and West Palm Beach have doubled, and many of today's buyers have concluded that vacation homes will continue to outperform stocks and bonds.

It's a smart bet, says Clark Thompson, CEO of the Web site The number of Americans reaching retirement age will increase 73 percent by 2011, and at least 40 percent of these retirees are expected to relocate--many to resort-type communities. In the next five years alone, baby boomers will add an estimated $100 billion in sales to the vacation-home market. "And in the wake of Sept. 11," adds Thompson, "people are reconsidering where they want to travel--overseas vs. something more local. Suddenly that place on the lake an hour away looks a whole lot more appealing."

(Are two homes better than one? Estimate the after-tax cost of owning a second home for personal use.)

If you do decide to buy a weekend getaway, here's a financial angle to consider: Interest rates on second-home mortgages are typically 1.5 percentage points higher than those on primary residences. (That's because default rates on second-home mortgages are higher.) See if you can get the cash to buy that second home by taking out a bigger mortgage on your first home.

4.) How much house can I afford?

Don't rely solely on your lender for an answer. "Mortgage companies don't care about your 401(k) or your vacation plans," says Stewart Welch III, a financial planner in Birmingham. "If you accept some of their deals, it'll leave you house poor--without enough money to invest for your future."

(Click here for a look at what your monthly mortgage payment will be on your new pad.)

We like the classic 28/36 rule (still used by most lenders), which limits post-purchase housing expenses (including mortgage payment, taxes, insurance and maintenance) to 28 percent of gross income and caps total debt obligations (from mortgage payments to credit-card and student loan payments) to 36 percent of gross income. Online calculators like CNN/Money's payment calculator or Fannie Mae's can help you do the math.

5.) With rates so low, does an adjustable rate mortgage really make sense?

It's hard to imagine a better deal right now than the good old 30-year mortgage. It locks in low payments and makes household budgeting easier. Most homeowners, however, don't stay put even close to three decades--in fact, half of all homeowners move within 8.2 years, according to the U.S. Census. That half might be better off taking an adjustable-rate mortgage (ARM), which offers very low rates for an initial period (say, three or five years) and then adjusts rates after that based on a market index.

Consider a couple borrowing $200,000. They'll pay $1,167 a month for a 30-year mortgage at the current low rate of 5.75 percent. Let's say they're pretty confident they'll move within five years for a job transfer or because they'll have started a family and require a bigger house. Their monthly payment on a five-year ARM (interest rate: 4.75 percent) comes in $124 lower, at $1,043. Over the five years, that's a savings of $7,440. On top of that, with the ARM they'll have paid down an additional $2,500 in principal at the end of the five years.

The risk, of course, is that our couple ends up staying in the house longer than planned. Most ARMs, after the initial fixed-rate period, adjust every year on the anniversary of the mortgage. Although lenders typically cap annual increases at two percentage points (with lifetime caps on increases as well), your rate--and your monthly payment--can soar quickly. Depending on market rates, if you stayed in the home any longer than a year after the initial fixed-rate period expired, you'd want to refinance.  Top of page

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