I remember back in the 1980’s when interest rates on a 30 year fixed rate mortgage were well over 10%. The majority of home buyers today would find these double digit interest rates insulting, laughable, and unconscionable compared to current interest rates that are less than 4%. So today I’m going to explain how rising interest rates will have a major impact on your purchasing power and why you should buy today even if you think house values are going lower.
I’m going to make this as simple as I possibly can. John & Sally are shopping for a home in today’s real estate market. Their combined income is $120,000. They have a $100,000 down payment and they know their property taxes will be $9,996 per year or $833 per month. They also know they will pay an additional $1,200 per year for Home Owners Insurance or $100 per month. Now based on their annual income of $120,000 or $10,000 per month they can qualify for a total monthly mortgage payment including their principal,interest, taxes and insurance of $2,800 per month. So let’s subtract their tax & insurance payment of $933 per month from their total allowable payment of $2,800 per month and we are now left with $1,867 per month that they can use for just their principal and interest payment. Now let’s determine how much of a mortgage they can borrow based on a 3.50% 30 year fixed interest rate. To determine this we need to know what the payment factor is at 3.50%, simply put this is how much it costs for every 1,000 you borrow at 3.50%. The cost per $1,000 at 3.50% is $4.49 amortized over a 30 year period. Now we can determine how much money they can borrow by taking the $1,867 they can use towards their principal & interest payment and dividing by the cost per $1,000 or $4.49. So take the $1,867 divided by $4.49 and that equals a mortgage amount of $415,812. Wow, Sally & John can borrow $415,812 at 3.50% based on a 30 year fixed rate mortgage.
Now let’s take that same scenario but increase the interest rate to 5.5%. When borrowing money at 5.5% the payment factor per $1,000 is $5.68. What kind of impact would this 2% increase have on John & Sally’s purchasing power? Remember at 3.5% they could get a mortgage for $415,812. With just a 2% rise in the interest rate they now only qualify for a mortgage of $328,687, ouch that’s a decrease of $87,125 in their purchasing power. In essence Sally & John would be much better off buying a home today at 3.5% rather than waiting to see if the real estate market goes lower while running the risk of interest rates going higher.
Remember you’ll never see the top of the market or the bottom because they both come and go in a blink of an eye.
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