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What happens when interest rates rise?

Interest rates /What is interest?

Interest is the fee that you pay to borrow money. On a home mortgage you are borrowing money from a bank to buy a house. They charge interest in order to mitigate their risk, and to make money. Interest rates affect buying power. This is especially true on mortgages which are compounded month over month, year over year.

When interest rates rise

Let's use an example using 4% interest. This interest rate is something that can be found in our market today (November 2015). There are typically 4 factors that go into your monthly payment: Principal and Interest (P+I) plus Taxes and Insurance (T+I). All four combine into what we call your monthly payment, or PITI. Since in this example, we won't know your taxes or insurance, we'll just use P+I.

Then I'll also calculate the P+I at a theoretical interest rate of 5%, which is something that may be coming soon, and 5.25 and 5.5%. I don't know what the future holds, but higher interest rates are coming.

Example A - 1% increase:

$300,000 purchase price, 3% down, 4% interest on a 30 year fixed mortgage: P+I = 1389.28

$300,000 purchase price, 3% down, 5% interest on a 30 year fixed mortgage: P+I = 1562.15

This increase of 1% in interest rate will make the monthly payment go up by $172.82 each and every month! Over 30 years, this is a $62,233.20 increase in interest because of the 1% increase in interest rate.

So calculating in reverse, if we are aiming to keep the same payment of 1389.28, how much house can I buy at 5% interest? Well, that $300,000 house has now become a not-so-affordable 12% increase in P+I.

If you wanted to keep the same $1389 payment instead, the new purchase price is now $266,801. That is a $34,000 decrease in buying power due to a higher interest rate. In other words, it is more than 11% decrease in buying power.

Example B - 1.25% increase:

I don't know if interest rates will rise by 1% or if it will be more than 1%. Let's recalculate this for a 1.25% increase.

$300,000 purchase price, 3% down, 5.25% interest on a 30-year fixed mortgage: P+I = $1606.91

Or $1389.28 monthly P+I mortgage payment = $259,369 purchase price

So the 1.25% increase yields a higher P+I monthly payment of $217.63. Or if you wanted to keep the same monthly payment, the purchase price is reduced by $40,000!

Example C - 1.5% increase:

$300,000 purchase price, 3% down, 5.5% interest on a 30-year fixed mortgage: P+I = $1652.27

Or $1389.28 monthly P+I mortgage payment = $252,249 purchase price

So the 1.25% increase yields a higher P+I monthly payment of $262.99. Or if you wanted to keep the same monthly payment, the purchase price is reduced by $48,000!

 

Additional Resources

Compounded Interest

 
Posted In: Buyers

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Steven Hong - RE/MAX Results 
REALTOR, e-PRO, GREEN, Old Home Certified 
7700 France Ave S #230, Edina, MN, 55435 
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