Is It Smart to Buy a Home During a Hot Real Estate Market?
The State of the Current Market
If lately you’ve been thinking about buying a home, you’ve probably heard the terms seller’s market and buyer’s market. But what exactly do these both mean? Well, let’s break these down using supply and demand. Currently, it’s a seller’s market. If someone is selling right now, they’ll be presented with more options because the number of buyers looking for homes is greater than the number homes available for sale. In this case the seller has the upper hand, hence the term seller’s market. The opposite happens when a buyer’s market occurs. Here, the buyer has the upper hand since the number of homes on the market is greater than the number of those looking to buy homes. The pandemic has cooped up people for over a year leaving many of them unable to go out and spend money. While there have been a lot of people who’ve been negatively financially impacted, others have accumulated more money than they normally do for a number of reasons. Society is starting to quickly pick up speed, and with that, an increasing appetite for things like real estate. Bidding wars are breaking out, some are buying properties never having seen them in person, and many homes are being sold at high prices even if they may or may not be worth the price tag. So, let’s discuss the important question… how will the seller’s market impact you?
Homes Appraising Below the Listed Price
In real estate, homes are given an appraisal value, which is an estimated value of the property. If a home is being sold at $400k and has an equal appraised value that’s good news. After giving, say a 20% down payment, or $80k, the remaining $320k is borrowed as a mortgage loan amount. An appraised value can indeed be lower than the listed price. Often, people don’t realize when getting preapproved for a mortgage, banks will lend you based on the lower of sales price, or appraised value. Therefore, financial planners advise individuals to go to their banks or mortgage brokers first, and obtain a pre-approval before looking at homes. The reason for this is to ensure a person has a clear idea of what amount they’re pre-approved for. No one wants to fall in love with a home they can’t afford. Assume this same $400k home is instead given an appraised value of $380k. In this case there are four things you can do:
- Negotiate with the seller to try and bring down the sale price to the appraised value.
- Negotiate with the seller to meet you somewhere between the sale price and appraised value.
- Continue with the purchase, and pay for the difference out of pocket.
- Walk away from the home purchase.
Assume however, a buyer agrees to continue with the purchase of a $400k home appraised for $380k. Since banks will lend based on the lower of the appraised value or the sales price, the down payment is determined to be 20% of $380K, which is $76k. The remaining 80%, which is $304k, is borrowed as a mortgage loan. It’s scenarios like this where buyers must cough up an out-of-pocket payment. This payment being $20k, as it is the difference between the listed price and appraised value. Restructuring the mortgage loan so the difference doesn’t come out of pocket can be done, but it will have an impact on the mortgage interest rate and your overall monthly payment, since you’ll also have to pay private mortgage insurance premiums due to the less than 20% down payment. Keep in mind, homes with lower appraised values also mean smaller principal and interest mortgage payments, due to a smaller loan amount. In this example, the homeowner is now paying roughly $67 less per month given a loan with a 3% interest rate. But buying a home that requires a large out-of-pocket payment may expose someone to the concept of opportunity cost. If instead the payment is invested, that amount of money has the potential to grow over time. For example, $20k invested at a 7% rate of return will grow to be over $150k in 30 years (the typical life of a mortgage loan). However, factors like owning the property for business purposes or a family living in the home and having better school options may be worth the out-of-pocket payment. Financial planners may be most important here because having someone who serves as a thinking partner will guide you through the many tangibles and intangibles to consider.
Homes Appraising at Higher Bids
In the case of a bidding war, buyers give multiple offers and eventually drive up the price of a home. Assume what was originally a $400k home is now being sold at $420k. If the increased listing price equals the appraisal value, how does this affect similar factors mentioned previously? In this scenario the out-of-pocket payment is $4k, which is the difference between the original down payment, $80k, and the new increased down payment, $84k. Again, analyzing mortgage payments, the loan amount now increases covering 80% of the appraised value, $420k, which means buyers will be paying increased mortgage payments. In this example, the homeowner is now paying roughly $67 more per month given a loan with a 3% interest rate. Bringing back the idea of opportunity cost, the out-of-pocket payment of $4k invested at a 7% rate of return has the potential to grow over $30k in 30 years. A buyer will also be giving up a little over $24k due to increased mortgage payments. This plus the potential investment opportunity totals $54k. When comparing the value of these factors between homes appraising at below the listed price and homes appraising at higher bids, the buyer has a lesser overall financial impact when purchasing a home in the latter scenario. In other words, the opportunity cost, what the buyer is giving up, happens to be less in this scenario.
Buying a home is a real in-depth process. It’s possible that under the current market a buyer will encounter these types of scenarios discussed. This is why it’s important to work with a financial planner in addition to your real estate agent and mortgage banker or broker. These professionals in your corner can serve as thinking partners and help you evaluate these important decisions. Oftentimes people think that you need to have a lot of money to work with a financial planner, but that’s not necessarily the case. Besides, choosing to hire a financial planner to help analyze your specific situation will guide you towards making the most informed decision.