I keep seeing these data-driven posts from the likes of Zillow and other major real estate analytics companies making claims that housing affordability remains strong thanks to low mortgage rates.
For example, Zillow mentioned that a home buyer earning the country’s national median income who purchased a median-valued home could expect to use just 14.8% of their income on a mortgage during the first quarter, down from 15.1% at the end of last year, but still considerably lower than the historic average of 21.2%.
At first glance, that looks pretty favorable, but then it occurred to me there’s a major flaw in these calculations. They all assume you’re putting down 20% on a home purchase, which we all know just isn’t the case.
Everyone Isn’t Putting Down 20%
Today’s average home buyer probably isn’t putting down 20% because home prices have risen tremendously over the past several years. It’s just not reasonable to assume that.
This would explain the many, many new loan programs that require little or no down payment, such as the recently launched yourFirst Mortgage from Wells Fargo, or the BancorpSouth mortgage that allows 100% LTV.
It seems every day a new zero or 1% down mortgage is being unleashed onto the market, hello Fifth Third and Guaranteed Rate, so it’s pretty clear many homeowners are struggling to come up with a 5% down payment, let alone 20%.
Tomorrow there will probably be yet another low-down payment option. In fact, it’s getting a little scary because a combination of no or low down payment with skyrocketing home prices could lead to trouble.
Anyway, my point about housing affordability is this. If we use real-world scenarios, the difference in monthly mortgage payments is stark.
Let’s Do the Math
For the sake of simplicity, let’s assume a borrower is buying a home for around $430,000 with about 3% down. That puts the loan amount at the conforming loan limit, $417,000, give or take.
Because they put down less than 20%, they have to pay monthly mortgage insurance, which at that loan-to-value ratio might cost $200 per month or so for a borrower with excellent credit purchasing a single-family home.
Seeing that the LTV is so high, they’ll also get stuck with a higher mortgage rate than a borrower putting down 20%, so let’s assume an interest rate of 4.25%.
Now let’s look at the 20% down purchaser buying the same home. They will put down $86,000 (most Americans don’t have anywhere close to this amount of money in savings) and snag a lower interest rate as a result, say 3.75% on a 30-year fixed.
Comparing Monthly Mortgage Costs
3% down borrower: $417000 loan amount @4.25% = $2,051 + $200 PMI = $2,251 per month
20% down borrower: $344,000 loan amount @3.75% = $1,593 per month
Monthly dollar amount difference: $658
Monthly payment percentage difference: 41%
As you can see, the borrower putting down just 3% has a monthly payment that is $658 higher than what many of these affordability studies will show.
That is certainly enough cash out of pocket to throw off the affordability numbers considerably, even if they are indeed relative over time. In fact, the monthly mortgage payment is 41% higher for the borrower putting down 3%.
So low mortgage rates, while undoubtedly beneficial, aren’t enough to offset much higher home prices because prospective buyers don’t have unlimited funds to keep increasing their down payments.
This explains the resurgence of low-down payment mortgage programs. But it also means affordability is going to get tight for a lot of folks.
The scary part is what happens once we can no longer rely upon record low mortgage rates? We’ll have homeowners with little skin in the game, high monthly housing costs, and fewer people will be able to afford to buy a home.
Whether that will do us in again remains to be seen, but if DTIs start getting stretched now, it’s just going to get worse. And articles telling you how affordable things are historically aren’t really reliable in my opinion because the era of 20% down has long since passed.
And maybe, just maybe, that home you’re looking at is actually kind of expensive.