I offered some thoughts yesterday on recent hubbub about the Fed’s increase in the Federal Funds Rate (All the talk about interest rates …). The short version of that post is that mortgage interest rates are much more dependent on market forces than on that very basic bank-to-bank rate.
I also made the point that the mortgage rates that have come to feel “normal” in recent years are actually less than half the average over the past 40-plus years, and less than 1/4 of the 18% peak rate in the 1980s. Assuming reasonably healthy economic conditions in the U.S. and internationally, mortgage rates will eventually rise. So what does that mean to consumers? (Note that although the following figures focus on the effect of interest rates on home buyers, they very much matter to home sellers because they can directly impact the number of buyers — i.e., market demand — with the ability to pursue any given property.)
For the purposes of this discussion, I assumed our hypothetical home buyer is using a 20%-down Conventional mortgage loan. Generally, the effect would be the same for FHA, VA, and USDA loans, but that assumption allows us to focus on just PITI (Principal, Interest, Taxes, and Insurance) without consideration of mortgage insurance and other fees that could accompany other loan types.
First, assume that a prospective buyer is targeting homes that are priced at $250,000. Mortgage rates have been just under 4% for the past few years, so I started there. I also assumed fairly typical factors to calculate the cost of property taxes and hazard insurance in Central Texas. This table summarizes what 1/4-point increases in interest rates would mean for that buyer’s monthly payment:
Many online mortgage calculators provide only the Principal & Interest component of the mortgage payment, but whether taxes and insurance are impounded from each monthly payment or not, they directly affect the buyer’s housing budget. In this example, a 1% increase in the rate, from 3.75% to 4.75% would increase the total payment by about $117/month.
Of course, shopping for homeowners insurance may yield a premium lower (or higher) than I’ve assumed, and the location of the home can change the property tax burden, but calculating the P&I part of the payment is just mathematics. A mortgage professional, knowing the specific circumstances of a specific buyer, can offer advice on buying the rate down or increasing the down payment or other strategies, but that table covers the basics.
Another way to view the buyer’s situation, using the same basic assumptions, is to consider “buying power” at a fixed payment of $1,600/month:
In this situation, an increase in the interest rate from 3.75% to 4.75% reduces the price our buyer can afford by $18,572.
Americans experienced very strong real estate markets and significant gains in property value with rates much higher than I have considered here, but the rates used in these tables should cover the foreseeable future. As history shows, sellers will continue to sell and buyers will continue to buy in virtually any interest rate environment, and rate changes will impact both. It is worth understanding and planning for, though.