Many homeowners are starting to feel the positive effects of an early recovery in housing prices. In fact, the widely-followed S&P/Case-Shiller Home Price Index, which is one of the broadest measures of national home prices, was up more than 10% for the 12 month period ending March 31, 2013.
For most prospective homebuyers, the process of determining how much house they can afford boils down to monthly payment amounts. By determining what one is willing to spend monthly on the mortgage payment, taxes and insurance, the actual purchase price of a home becomes a variable that is solved for.
Consider a prospective homeowner who is willing to put $83,500 of equity from a prior home sale down on a new house and spend $1,500 per month on mortgage principal and interest. At a current rate of 3.5% interest for 30 years, $1,500 per month yields a total loan amount of roughly $334,000. Adding in the 20% down payment of $83,500 yields a total purchase price of $417,500.
Now consider the exact same situation, but with the 30-year mortgage rate at a more historically reasonable 6.0%. A $1,500 principal and interest payment at 6% for 30 years yields a total amount to be borrowed of just $250,000. We can assume that the prospective buyer still has the same $83,500 to put down, so the total purchase price comes out to $333,500.
So, a bump up in the 30-year mortgage rate from 3.5% to 6.0% in this case leads to a 20% decline in the purchase price of a home for someone who is willing to spend $1,500 per month on principal and interest.
Admittedly, there are countless economic factors that drive the overall housing market, but interest rates have a very significant effect. When mortgage rates start to climb, will the other factors be enough to outweigh the increased cost of financing?
Questions or comments are welcome.
Christopher W. Frayne, CFA, CFP®