As we emerge from two very unusual years, many of us who may have been putting off the purchase of a home may be considering entering the housing market. Home prices have remained steadily high despite fluctuations in other investments, and a real estate investment can be an important hedge against inflationary pressures — in an era of high inflation, investing in real property can be a critical way to avoid holding cash that becomes less valuable by the day. With steadily rising prices, real estate can be a great investment, in addition to providing a place to call home.
However, inflation is only one factor that potential buyers should consider before embarking on a home buying journey. Rising interest rates, a reaction to high inflation, can have an outsized effect on homebuyer “purchasing power” — that is, the value of the home you can buy with each dollar you have to invest. Understanding how rising rates affect purchasing power, and what you can do to maximize your investment dollar, is an important consideration for homebuyers.
Understanding Homebuyer Purchasing Power
For most homebuyers, the most important number to consider when buying a home isn’t the overall list price of the home, it’s the home’s total monthly cost, including the mortgage payment, property taxes, and the cost of homeowners insurance. As you budget for a home, this monthly rate is critical, and ultimately determines the amount you’ll be able to borrow. One of the most important factors determining a buyer’s mortgage payment is the interest rate charged for the loan. Because most mortgages last for 15 or 30 years, this rate can have a surprising impact on your purchasing power.
How Do Interest Rates Affect Purchasing Power?
In a fixed-rate loan, the interest portion of the loan is amortized over the life of the loan, meaning that each payment is the same amount, and includes an amount for both principal and interest. A higher interest rate, then, results in a higher monthly payment over the entire life of the loan.
Mortgage lenders generally qualify borrowers according to a number of factors, including the buyer’s debt-to-income ratio, or DTI. This calculation divides the borrower’s monthly income by monthly debt obligations. Lenders generally cap the allowable monthly DTI ratio at 45% of income, restricting the total amount — principal and interest — that you can borrow.
Even seemingly small changes in the interest rate can have a large impact on the total amount you will qualify to borrow. For each 1% increase in interest rates, the total amount a buyer can borrow declines by approximately 10%. For example, a borrower with a $1,500 budget for principal and interest, excluding property taxes, insurance, and other costs, can reasonably expect to borrow around $354,000 on a fixed-rate 30-year loan at an interest rate of 3%. At an interest rate of 4%, however, that same borrower can only borrow around $314,000. At 5%, that borrower’s purchasing power declines further, financing only around $279,000. These significant swings can have an outsized effect on your home search, particularly in a competitive market where prices are rising regularly.
What Should Buyers Expect In The Second Half Of 2022?
As most home searchers are acutely aware, interest rates are on the rise. This increase is due to inflationary pressures on the economy, which have led the Federal Reserve to raise the federal funds rate — the interest rate at which banks are able to borrow from one another overnight. Although the federal funds rate does not have a direct impact on mortgage rates, it is used by lenders as a key benchmark to set long-term interest rates for borrowers.
The federal funds rate was recently raised by ½%, a substantial increase, in an effort to reduce the availability of money and combat significant inflation. This increase has seen interest rates on all kinds of debt, from mortgage rates to credit card interest, begin a steady trend upward. This trend is expected to continue, as the Federal Reserve continues to restrict borrowing in an effort to cool inflationary pressures on the economy as a whole.
What Should Buyers Do In An Era Of Rising Interest Rates?
A number of factors go into the calculation of a buyer’s interest rate. Some of these factors, such as the federal funds rate, the bond market rate, and inflation, are outside a buyer’s control. Others, however, can be influenced by a buyer’s overall financial health. Even in an era of quickly rising interest rates, a larger down payment and strong credit can help a buyer score the lowest possible rate. Paying down your debt, improving your credit scores, and saving money for a higher down payment are all critical steps that can go a long way to improving your purchasing power.
In addition, if you’re pre-approved for a mortgage and ready to buy, consider seeking a “rate lock” from your mortgage lender. A rate lock ensures that the mortgage rate won’t change between when you secure the lock and the closing date, as long as you close within the specified time frame (usually 30, 45, or 60 days) and there are no changes to your mortgage application. In an uncertain environment, this lock can offer peace of mind as you complete your home search and purchase. Most of the time, locking in your rate will require locking in your home (e.g. having a signed contract), but there are some innovative solutions out there and it’s worth consulting with your lender for options.
Working with market experts can also help to ensure that you get the best value for your homebuying dollar. From sourcing lower-cost inventory to connecting you with mortgage lenders who can reduce your costs and find you the best deal on a mortgage rate, Baird & Warner can help you maximize your investment at every step in the homebuying process.
When Home Means More, You Need a Team With More to Offer
Home is about so much more than just four walls — your home is your most valuable investment. Buying or selling a home is a big deal, and in an uncertain economy, our homes have never been more important. That’s why your local Baird & Warner agent is with you at every step of the way, from finding the perfect home to connecting you with local experts in mortgage and title. Whether it’s the beginning of a story or the end of a chapter, we’re here to help.
