It’s Finance Friday, and Michael Schneider writes about taking out the biggest loan most people will see in their lifetimes: a mortgage. Seeing the difference between a 3% and 7% mortgage over 30 years was a real eye opener for me!

THE BIG STORY

How Interest Rates Impact Mortgages

When the egg definitively comes before the chicken

The Federal Reserve has raised interest rates several times in the recent past to reduce inflationary pressures. I will take your word that you aced your high school Econ class and know that there are trade-offs to any monetary policy such as raising interest rates, one of which is mortgage rates. But what is the actual difference in dollars and what are the second order effects of rising mortgage rates? We will dive into these topics and also discuss your options when considering moving and a new mortgage.

If you bought a house several years ago and locked in a mortgage rate around 3%, congratulations! There are many new and prospective homeowners who are quite jealous. For those future or recent homeowners — while the Federal Reserve is not trying to stick it to you with higher mortgage rates, they are bound to meet their goal of promoting price stability (i.e. inflation) and maximizing employment - and their primary lever to do this is the federal funds rate. When the Fed increases the federal funds rate, it makes it more expensive for banks to borrow as well, and thus the effects ripple to your mortgage and other loans costs. Mortgages are often talked about as the bedrock of American financial stability and a way for the ordinary citizen to build wealth. But as rates rise, that dream becomes clouded. Let’s look at an example using the median home price in the U.S. of $418,800. Currently, mortgage rates are around 7.65% for a 30-year fixed rate, so assuming you put a down payment of 20% on the median priced home, your monthly payment would be $3,208. Now if we use a 3% rate, the monthly payment is $2,243 or a difference of almost a thousand dollars a month! If this isn’t drastic enough, when viewed over the 30-year period of the loan the difference is staggering. The total interest payments for the 3% rate is $173,476 but with the 7% rate it is $520,734, a gigantic difference! What about a VA home loan, for which I don’t have to make a down payment? That is an option, but the principal balance — the total value of the loan — increases, and then the interest rate is applied to that larger sum, leading to even higher monthly payments. I’m not saying a person should avoid using a VA home loan — in fact I used one to purchase my home — but one should recognize up front the trade-off involved by not making a down payment.

These increased rates affect not only monthly mortgage payments, but consumer spending and other economic factors. Service members are particularly vulnerable in this situation given the frequency of moves, and this is also seen in the general housing market. One tool to help is the Price-to-Rent Ratio, which can estimate if it is better to rent or buy in your location. Mortgage payments typically make up a large, if not the largest, portion of a household’s monthly spending. If those payments increase, families may be forced to cut spending elsewhere and thus the overall economic impact can be much sharper. Additionally, one important second order effect to consider is economic mobility. The American dream is based in large part on the ability to improve one’s economic status but the rise of mortgage rates is now weighing on that. One example of this relationship is the ability to move for a better job. If I receive a job offer in a different city I face the difficulty of weighing changing mortgage payments, and am less likely to take the new job given the personal financial hurdle of taking on a higher mortgage rate. 

There are potential solutions to this issue though. A little known fact is that a VA home loan can be transferred between a seller and buyer - yes, you could assume the interest rate and terms of the loan! Another option is to take a higher rate with the hopes of refinancing your loan when rates drop. Here are the general requirements to refinance which include closing costs of around 2 - 5% of the total loan amount.

While there is uncertainty surrounding when interest rates will drop, I hope you can use some of the tools in this article to help make better informed decisions when it comes to moving and purchasing a home. The American Dream is certainly not lost, but the desire for home ownership may need to be reconsidered while things stabilize. 

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