Home Ownership Costs: Mortgage Interest Rates and Loan Balances
Low or falling mortgage interest rates are better for housing costs than high or rising rates.
From a consumers point of view, higher interest rates are bad because borrowing money becomes more expensive. All things being equal, higher mortgage interest rates make for a higher cost of ownership and visa versa. When actively looking to purchase a home, shopping around for the lowest rate can save thousands of dollars over the life of the loan. The Consumer Financial Protection Bureau launched a Rate Checker to help consumers verify if the rate they are quoted is good or not.
Since rising mortgage interest rates makes borrowing more expensive, it’s also detrimental to home prices, so nobody in real estate relishes the idea of higher mortgage interest rates.
In a previous post I discussed the four variables that determine the purchase price of a property:
- borrower income,
- allowable debt-to-income ratios,
- interest rates, and
- down payment requirements.
Today we look at interest rates.
Interest rates are the yield on debt instruments. If investors lose their appetite for mortgage debt, prices of mortgage-backed securities go down, payment yields go up, and mortgage interest rates go up with them. The Federal Reserve heavily influences the yield investors require by adjusting the Federal Funds Rate, the base rate all yields are compared to.
Interest Rates have a major impact on loan balances
Interest rates are critical because it determines how much someone can borrow. The same payment at different interest rates produces significantly different loan balances. When lenders calculate the size of the mortgage a borrower can sustain, they plug in the interest rate and the maximum payment (calculated by applying maximum debt-to-income ratio to gross income).
For example, if a borrower makes $100,000 per year, the lender will allow them a maximum yearly debt-service of 31%, or $31,000. Divide that by 12 to get $2,583,33. Some amount is taken out for taxes, insurance, and HOAs leaving a remainder amount to cover a mortgage payment. The lender then takes that payment amount and plugs it into a formula to determine the maximum loan balance. At low interest rates, this amount is quite large, and at high interest rates, the supportable mortgage balance is much smaller.
Back in 2006 house prices were inflated because nobody could afford them using stable, conventional financing. Through buying mortgage-backed securities, the federal reserve worked to bring mortgage interest rates down from 6.5% to 3.5%, which made the insane prices of 2006 attainable in 2015 despite weak wage growth. Such is the power of low mortgage rates.