No, I’m not talking about the upcoming primary, although that would probably be an apt title. The reason my posting has been so infrequent this past week was that I’ve been looking at homes in Northern Virginia, one of the “hottest” real estate markets in the country. What I saw was enough to scare me back onto the sidelines for the time being.
Realtors and mortgage lenders told me repeatedly that the run-up in prices was due to the growth in the DC area combined with low interest rates. To be sure, those things have played a factor. DC is growing, and interest rates are low. However, in my opinion and experience, there are two factors that have heated housing to the level of a glowing lava dome.
1) “Creative” financing
Long gone are the days of a 20% down payment. These days, you simply borrow the down payment as well. The second mortgage (HELOC, deed of trust, whatever) almost always floats with some index rate. I could have gotten a second mortgage tied to Fed rates, LIBOR (a British index), or COSI (a private mortgage index). I’m sure I could have gotten a second mortgage tied to the prime lending rate of the Central Bank of Indonesia if I had wanted one.
When I expressed concern to a lender that a down payment would take all of my cash reserve, the response was that no one really puts any money down anymore, and an 80%-20% mortgage would be a good way for me to hold onto my savings.
When I pointed out that a second mortgage would float, and that any change in interest rates would immediately affect my monthly payment, I was told that I could simply refinance once the house had appreciated enough.
Even scarier are the interest only loans and negative amort loans. Interest only loans speak for themselves – you pay only the interest. I don’t even know if your neighborhood furniture store offers such an option. If the home doesn’t appreciate, you have NO equity. Negative amort loans are the minimum payment credit card version of mortgages. You pay some minimum payment, which doesn’t even cover the interest charge, and the interest accrues with the principal.Fully 1/3
of the mortgages issued in the Washington area this year have been interest only loans. That means that 50% of all homeowners buying into the market are betting on appreciation to increase their equity stake. Some will pay down the principal with additional payments, but the reality is that most won’t.
2) The transient nature of the area
Creative financing, in and of itself, is not a bad thing. When used responsibly, it can be a good way for people to meet their personal financial goals. The problem is that creative financing depends on a certain percentage of people who are playing by the rules. In the housing market, that has traditionally meant a 20% down, 30 year fixed mortgage.
When 90% of the buyers in a given market are using traditional mortgages, then that market is grounded in the fundamentals. There’s some room at the fringes for people willing to use riskier financing instruments. But when 30-40% of the market starts using creative financing, then the entire market has broken free from its moorings.
The DC area is so transient that people make their housing decisions on 3-5 year timeframes. People are taking a short-term view of their financing and interest costs. Individually, not a problem. But when 10s of thousands of people make the same decision in concert, the result is a flow of cash into the market. It’s a seller’s bonanza.
The underlying value of a home is in its ability to provide shelter. I can rent the same size place, in the same neighborhood, for 50% of what my mortgage, taxes, and HOA would have been! It’s true that tax deductions would have offset some of that, but maintenance expenses usually eat up the tax benefits.
Two years has always been considered the break-even point on the rent/buy decision. Using that rubric, I would need to see 12% appreciation in each of the next two years in order to justify a decision to buy. Will the DC area see that? Possibly. But it won’t be because I put any money into the market.