If you’re like most people, when purchasing a home you think about your monthly payments rather than a certain mortgage amount. You arrive at a payment amount that you can afford each month, and that along with your down payment amount determines the kind of home you can buy in terms of price, size, and location. This is the key to understanding buying power and the role interest rates play in your calculations.
As you no doubt have heard, we are just off our historically low interest rates. Still, today’s rates of between 3 and 3.5 percent are remarkably low and that translates into great buying power. When I started selling homes, loan interest rates were 18 percent — really. People still bought and sold but, as you can imagine, their buying power was much lower than it would be today.
Let’s talk about buying power in the context of today’s rates, and how buying power will change as rates go up, which they will. I consulted with Tim Wood of Terra Mortgage in Larkspur for some of this information.
Let’s say you are comfortable with a $4,500 monthly mortgage payment. Given that payment, with a 3 percent interest rate, you could afford to purchase a $1,334,190 home. This assumes you are making an amortized payment (paying both interest and principal) on a $1,067,352 mortgage, which is your actual loan amount after putting 20 percent down on the property.
What happens as interest rates creep up? If interest rates rise to 4 percent, your buying power goes down. That same $4,500 monthly payment will only buy a $1,178,219 house, based on a $942,575 mortgage. Just a 1 percent increase in the interest rate lowers your purchasing power by $155,970. In today’s competitive market where prices are rising, that could make the difference in getting your offer accepted.
Interest rates will rise as the government eases off its bond-purchasing program, which has helped keep rates down in recent years. The end of this program seems inevitable, and some suggest mortgage rates may climb as high as 6 percent in the next year or two.
How does that affect your buying power? With your $4,500 monthly payment, it lowers the loan amount you can qualify for to $750,562, and your purchase price affordability drops to $938,202 — nearly $400,000 less than the initial amount for which you qualified. You can imagine how much this affects the type, quality, and location of the home that you can purchase.
Wood offered some additional information. For a $1,100,000 purchase with 20 percent down and 3.5 percent interest, your monthly payment would be $3,592. Your minimum income requirement would be $132,000 per year. If interest rates rise to 4.5 percent, the monthly payment climbs to $4,459, and your income requirement jumps to $155,600 per year. With interest rates at 5.5 percent, then your monthly payment climbs to $4,997, and the income requirement to $170,250 per year. As these examples illustrate, your buying power shrinks as interest rates go up.
Prices will most likely continue to rise. Yes, they might level off as interest rates climb, but you can see how waiting will not necessarily get you more house. When house hunting you should always engage a real estate agent you trust, and get fully preapproved with an excellent lender. That way you’ll know your buying power when looking for that perfect home, and you’ll find properties as soon as they come on the market so you can take advantage of the best rates available.