Beeeeeee Careful
October 20, 2023
You should not buy a house right now with low money down and > 7% rates without ample cash reserves.
Why is this? After all, the less you can put down on a house and the more you can finance, generally the better off you are. However, in today’s environment, this can backfire.
For example, let’s say you’ve saved up enough for 10% down. You put 10% down and take out a note at 7.5% and you can make the payments, albeit barely because you just doubled your monthly costs when compared to the house you were renting. But, it’s ok, you can refinance when rates drop everyone tells you.
Now, let’s assume rates drop and you want to refinance. Good idea. Except when it comes to a refinance, you’re looking at being able to borrow a max of 80% of your house value and typically it’s more like 70% to 75%. So, now it gets fun.
You bought your house for $1mm and borrowed $900,000. 3 years have passed but have values risen? Let’s say they have at a rate of 4% per year or 12% (non compounded) over that 3 year period. Your house will appraise for $1.12mm. If this is true and IF you can borrow 80% on a refinance, you take out a loan for $896,000. But, if you’re limited to 70%, you’re limited to $784,000 meaning you would likely need to put another $100,000 of cash in to get the refinance done.
Now, what happens if in the short run your house doesn’t appreciate and stays flat? Now, you’re looking at a max of $800,000 on the loan or even $700,000 meaning you may need as much as $200,000 of cash to get the refinance done.
You could very easily find yourself in a situation in which rates DO fall but you can’t refinance because you can’t put in enough cash to meet the loan to value requirements.
Now, let’s address the variable component. Typically, a variable rate note will price at a spread above WSJ prime or a specific treasury yield. However, the rate you start out with is often not priced at this metric but is priced lower. What this means is that when the fixed rate period is over and you go to the floating rate, the jump in rate may be larger than you expect. Moreover, these loans often have a rate floor meaning if rates fall, yours does not fall accordingly. So, in this scenario in which you have a relatively high floating rate loan, you could find yourself in a situation where market rates fall but your rate does not and you can’t refinance because you don’t have enough equity or cash to pay down the note.
The lesson here is a low downpayment note with a variable interest rate, particularly in a high rate environment is a risky gamble. It’s ok to take that risk but ideally you would maintain ample reserves to cover the risk should it go bad on you.
Now, all that said, if you can borrow 90% of your home’s purchase price, you should absolutely do it if the rate is reasonable in the current climate. Take the excess funds you’d have spent on a downpayment and invest it in higher return investments.