With the Federal Reserve working to squash inflation by continuing to hike the Fed Funds Rate, one consequence for consumers is that the cost to borrow money has gone up.
One headline credit product we are all conscious of and sensitive to is a home mortgage. US Mortgage Rates recently rose above 6% for the first time since 2008. With this month’s Fed decision, they’re up even higher. This can be disconcerting for those of us who are looking to relocate after the pandemic, or need to borrow to fund a home renovation as a necessity to stay in place. Pre-Retirees and retirees also may have planned to buy a second home, move to a lower income tax state or purchase in a retirement community, but didn’t anticipate the current housing and interest rate environment.
Let’s take a look at some options to consider when making decisions while navigating the current rate and housing market.
Earlier this year, ACM Partner and Portfolio Manager Dr. JoAnne Feeney discussed how homebuilders will need to ramp up development to satisfy the demand from millennial buyers looking to purchase homes. New units will take time to be added to available inventory, so in the meantime, rising mortgage rates should bring down home prices via a housing correction. Mortgage rates are higher relative to what we’ve seen over the past several years, but they are still lower than historical averages and particularly relative to the late 70s/early 80s when inflation and interest rates were at all-time highs.
In certain situations, a mortgage might still be the most viable option, depending on the structure and what the intended use of the new home will be.
If you’re buying a new primary home, then remember that mortgage interest remains tax deductible, for those who are itemizing deductions, on mortgage balances up to $375,000 (filing singly)/$750,000 (married filing jointly) of primary home mortgage debt. For a mortgage amortizing over 30 years, the first few years of payments are primarily comprised of paying back interest. This results in bigger tax deductions in the early years so the effective, after-tax interest rate on your mortgage might not be as high as you think if you’re itemizing deductions and in a higher tax bracket.
If you’re buying a second home or vacation home, you might be better off refinancing your primary home and taking cash out if the rate is similar to that of a purchase mortgage in order to preserve and take advantage of the interest deduction on a primary residence.
Adjustable-rate mortgages tend to have lower rates than 30-year fixed-rate mortgages and might make sense as well. Adjustable-rate mortgages are structured so that the interest rate is fixed for an initial period (typically 1-10 years) and then will adjust or “float” every year thereafter depending on the level of interest rates following the initial period. You may be buying a forever home, but you don’t have to keep a mortgage forever. If you expect that interest rates will eventually come down once inflation comes back in-line with the Fed’s long-term target, then you might have the opportunity in the future to refinance at a lower rate. For example, many borrowers refinanced their mortgages when rates dropped as the Fed slashed interest rates following the outset of COVID-19 in 2020. If you plan on paying off your mortgage over a shorter period of time or if you don’t expect to own the property for the long-term, then paying a premium to maintain the higher interest rate on 30-year fixed-rate mortgage may not make sense.
There are alternative lending options besides mortgages as well. We’ve highlighted in the past the ability to collateralize your taxable investment account through margin or a securitized line of credit. Depending on your financing needs (the expected time you expect to keep the debt outstanding, current borrowing rates and the value of your taxable account), using a line of credit to facilitate a real estate purchase could make sense. If the line of credit is used to purchase an investment property, then the interest paid could be considered investment interest and used to offset other investment income.
Lastly, you could consider using other assets that no longer match their initial purpose. If you own permanent life insurance that was originally purchased to replace the primary earner’s income while working, then you may have built up substantial cash value in your policy. Depending on the terms of the policy, you may have the ability to borrow against it or even withdraw the cash value without creating an income tax event. It’s always good practice to review your life insurance as part of your overall financial plan to make sure it still serves a purpose.
In all of these scenarios, you would want to speak with your ACM Advisor to discuss the pros and cons of each strategy, and what tradeoffs you may have to make in moving forward with a change to your real estate situation. Like all markets, the current real estate and interest rate environment will change over time, which might result in the need to take a different approach to meeting a housing need or goal. Even if you decide the current environment makes it the wrong time to move forward, understanding your options may help you make a sound decision.