“I don’t plan to sell my house right now so I don’t care how rising mortgage rates may impact the value of my house.” This is what I was recently told by a friend over dinner. I responded that I wasn’t talking about the immediate impact, but what about the impact in a year or two if you were looking to sell at that point? How might a mortgage rate increase change what someone may or not be willing to pay for your home? In other words: If interest rates rise what happens to house prices?
Home Affordability Explained
Admittedly there are many factors that play into whether or not home values increase or decrease, but there is one factor that I believe has the biggest impact, and that is home affordability. Affordability in this context has to do with how much someone is able to pay each month in principal and interest for their home.
Whether your budget allows you to pay $1,500, $3,500 or $10,000 per month for a mortgage payment, that is how much you can spend. For most people in the market for housing, it’s a fixed amount that doesn’t change much over time. Unless the economy is growing and you are earning more money, the amount you have earmarked for housing costs is limited and determines how much you will spend.
To illustrate, let’s do a home affordability experiment. Let’s look at today and compare it to a future time when mortgage rates could potentially be higher.
Your Monthly Housing Budget, Today
As of this writing, the average interest rate on a 30-year fixed mortgage is about 4.75%. At that interest rate, we could purchase a $700,000 home and put 10% down, or $70,000. This will leave a mortgage of $630,000 or monthly payments of $3,286.38.
Over the life of the mortgage, we will pay back the original $630,000 borrowed plus interest of $553,096. If we include the down payment, the total cost for this house will be $1,253,096.
Your Monthly Housing Budget in Two Years
Two years from now someone is looking to purchase a home and 30-year mortgage rates are now 6.50%. They know their monthly home financing budget allows for exactly $3,286.76 per month. How much “house” can they buy?
At that price they could put 10% down, or $57,777, financing the remaining $520,000 at 6.50%. Over the life of the mortgage they will pay back the original $520,000 borrowed and interest of $663,231. If the down payment is included, the total cost for the home will be $1,298,786.75.
To learn more about how interest rate changes might affect your particular housing situation, try this mortgage calculator from Realtor.com.
If Interest Rates Rise, What Happens to Sellers?
If you already own your home and plan on staying for a decade, increasing mortgage interest rates will mean nothing to you. However, if you are thinking of buying or selling within the next year or two, rising rates could have a significant impact on your personal finances.
For sellers, the house you could sell today for $700,000 – because the buyer can “afford” a monthly payment of $3,286 – would have to fall in price to $577,777 to be funded by a 30-year 6.5% mortgage and 10% down. To buy the $700,000 home originally mentioned, the buyer’s income would have to increase to the point where they could “afford” $3,982.03 per month – the mortgage payment for $630,000 financed at 6.50%.
It might not sound like a huge difference at first but do the math. That $696.03 monthly increase equates to $8,352.36 more per year. Put another way, the buyer would have to be willing to spend 21.18% more per month on their mortgage. I don’t know about you, but I don’t see a lot of people getting 20%+ salary increases.
If Interest Rates Rise, What Happens to Buyers?
If you are thinking of buying a home today, the biggest determinate will be how long you plan on staying in the home. Of course, there are other factors like supply and demand, taxes, location, etc., but how long you plan on living in the home will drive your decision whether to buy now or maybe rent and wait for prices to drop.
From the example above, we see that if you plan on staying in the home for 30 years, which many people don’t do anymore, you would be better off from a “total cost” perspective to buy today, $1,253,096 versus $1,298,786.89 for the 4.75% and 6.50% mortgages respectively.
Even if you believe that home prices are currently inflated because of low mortgage interest rates, those low mortgage rates today will save you money over the long term. However, if you plan on buying today and selling again in the next couple of years, you may be taking a risk that could backfire.
The Bottom Line on Rising Mortgage Rates
Unless there are extenuating circumstances, such as a booming economy or the local real estate market is absolutely on fire, it is likely that higher mortgage rates will have the effect of lowering home values. It comes down to affordability and simple math.
In summary, there are a ton of factors that go into home values, and the interest rate is definitely not the only one. Each real estate market behaves independently. However, in my opinion, affordability is the biggest factor when people buy homes, and that comes down to the monthly payment determined by the principal and interest due on the mortgage.
As mortgage rates rise, monthly payments on new mortgages will as well, which means home prices will likely have to fall to encourage new buyers into the market.
If you haven’t recently reviewed your financial plan you should contact your CERTIFIED FINANCIAL PLANNER™ Practitioner.
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