By Thuong Thien, CFP
Interest rates were raised by the Federal Reserve for the sixth time this year, including 75 basis point increases in June, July, and September, to slow inflation. Then in November, the target range for the federal funds rate increased to 3.75% - 4.00%. Although that won't affect any existing debt you hold at fixed interest rates, it can impact your finances…and your quest to buy a home.
So, intuitively, this may not be the time to apply for a new loan. However, suppose you believe you're ready to buy a home or hold existing debt at variable interest rates. In that case, there are strategic ways to manage your finances so you don't become overburdened by high interest.
Should you buy a home now?
The homebuying market has presented a pickle of late. This fall, as home prices were beginning to wane, mortgage interest rates leapt to more than 7% on a 30-year fixed loan and nearly 5% on the 10 Year ARM (an adjustable-rate mortgage that guarantees a fixed interest rate for the first ten years).
However, there are a lot of factors in today’s home-buying equation. The Fed is expected to continue raising interest rates in the coming year, albeit perhaps not quite as aggressively. This may cause a drop in home prices to attract more buyers. In contrast to the booming residential market of recent years, this scenario presents an opportunity to buy at lower prices – which can help offset the pain of monthly payments at a higher interest rate.
Ultimately, there are three main factors to help you decide if you should buy a home now:
- You have a strong desire or a need for a house (e.g., a need for more bedrooms because your family is growing).
- You have at least 20% down payment.
- You’ve calculated the monthly all-in cost of owning a home and your family’s salary can support it, along with all other expenses in your life.
Below is an example. I didn’t put in maintenance cost but if your home is older, you can estimate how much that might be on a monthly basis.
Monthly cost of owning a home:
$1.5 million purchase price, 20% down payment, 5% 10-year ARM:
Mortgage (principal & interest)
Property Tax (1.15% in San Mateo County, CA)
Basic homeowners Insurance
The most prudent interest rate is a 30-year fixed. However, in the current environment, you may want to consider a 10-year ARM instead. I’ve heard it several times now from realtors, “You date the rate, and you marry the house.” In other words, hopefully rates go down and you can refinance.
Is it smarter to continue renting and delay buying? That depends on how much you’re paying in rent. According to analysis by the Dallas Fed, rent inflation tends to lag rising home prices by about a year. Based on the state of the housing market last spring and throughout the summer, the Fed projects rent inflation will continue to increase – from 5.8% last June to 8.4% in May 2023, at which point rents should begin to drop again.
However, your rent won’t change until the end of your lease. While you may be able to negotiate a new lease rate, it’s not likely to be less than what you’re paying now. You can shop for a cheaper rental or get prequalified to see how much house you can afford. You may find a well-priced home that’s worth paying today’s higher interest rates. If you find a home you like in your price range, you can always buy now and refinance later.
Should you consolidate debt?
Let’s talk about existing debt, particularly the impact of high interest on credit card balances. According to CreditCards.com, the average credit card interest rate in November topped 19%. In addition to higher minimum payments, that interest will increase your balance by leaps and bounds. Now is the time to be aggressive about paying it off. You have some options for this.
For example, you might take advantage of a balance transfer offer from another credit card that waives interest for six months or longer. Be sure to note how much you’ll pay in a transfer fee, which is generally a percentage of the balance conveyed. If you go this route, remember that the key is to pay off that balance before the term is up, when you’ll switch to paying a high interest rate. If your plan is simply to get temporary payment relief, this strategy may not be in your best interest. Between the transfer fee and higher interest down the road, you could be worse off.
Another option is to consolidate your debt with variable interest rates into a personal loan. Unsecured personal loans typically have fixed interest rates and a fixed term, such as three or five years. This presents another pickle. If you’re overloaded with debt, you may not have a great credit score. And yet the interest rate on your personal loan will be based on your credit score (as well as your income and income-to-debt ratio).
According to ValuePenguin, personal loan rates for people with an excellent FICO score (720 to 850) range between 9% and 13%. It may be worthwhile to shop personal loans to see what rate you can get and what your monthly payment would be but mind the fees and compare this consolidation tactic to your current payment plan.
Your credit score is your golden ticket to everything you want to buy in life. Protect it above all else by paying your minimums on time, every time, and keep those balances low.
Should you tap home equity?
If you own a home, you have additional options for managing variable-rate debt. Let’s assume your property is either paid off (that would be lovely) or has a fixed-rate mortgage. You don’t want to end up with two variable-rate mortgages because you will have little control of your budget when interest rates climb. If you have at least 15%-20% equity, you may qualify for a home equity loan (HEL) or home equity line of credit (HELOC).
The HEL pays you a fixed amount of money and charges a fixed interest rate on that amount. A HELOC provides a credit line that you can tap as needed, and you pay a variable interest rate on whatever balance you withdraw. Both types of loans will have a specific term, say ten or twenty years, and both use the value of your home as collateral – which is why interest rates are lower than a personal loan or credit card. According to Bankrate.com, in November the average HEL interest rate was 7.29%; the average HELOC was 7.30%.
Both loans can be used to consolidate higher-rate debt, but there are caveats to consider. With a HELOC, the lender can cut you off if the economy experiences a downturn. Your payment term will still apply, so it’s not as if you’ll have to pay back all the money you’ve borrowed immediately.
However, they can discontinue your access to the unborrowed balance, or offer to convert the full line of credit to a fixed equity loan. This means the balance will be paid out and you’ll be required to make regular payments on the loan. Think carefully before accepting that offer; the extra cash could prove tempting, but it will add to your debt payments and likely reduce your credit score.
And finally, any loan or line of credit you take out using your property as collateral puts your home at risk of foreclosure should you get behind on your payments. It’s one thing to consolidate debt, but this is not the vehicle to fund a wedding or an expensive vacation – that is just taking on additional debt.
What about student loan debt?
Do you have student loans? Be patient. In November, a federal appeals court placed a nationwide injunction on the new student loan debt relief program until a pending lawsuit is resolved. The Biden administration announced on June 22 that it was extending the moratorium on student loan payments through the end of June, allowing the Supreme Court to hear the case in its current term.
One thing you should absolutely not do, at least not yet, is consolidate federal student loans with a private lender because they will cease to be eligible for federal forgiveness. There are other debt assistance programs you may apply for, such as income-driven repayment plans based on earnings, the Public Service Loan Forgiveness program if you work for a non-profit, or student loan assistance benefits from your employer.
Sometimes money just falls into your lap, like a year-end bonus, the sale of property, e.g., boat, spare car, estate transfer gifts or inheritance. Be disciplined. You may want to use part of your windfall to pay down debt – specifically variable interest-rate debt.
It’s important to utilize credit to establish a good FICO score, but there are some basic tenets to follow. First, live beneath your means – buy a home that still leaves you plenty of discretionary income each month. Do not charge more on your credit cards than you can pay off each month. And finally, once again: Concentrate your efforts on boosting and preserving your credit score. Maintaining a high score will reward you with lower interest rates on loans you apply for in the future.
About the author: Thuong Thien
Thuong Thien, is a CERTIFIED FINANCIAL PLANNER™ with expertise in investment, tax, and retirement planning for high net professionals, including many female business executives. With more than 16 years of investment industry experience, she currently serves as a Principal and Senior Financial Advisor at Team Hewins in Redwood City, CA. Thien holds a B.A. in economics from UCLA, with Minors in Global Studies and Southeast Asian Studies.
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