The United States housing market has been going gangbusters for the last several years as homeowners have seen the price of their property increase considerably. It seems as though homes have quite literally been flying off the shelves, often for well over the asking price and without the need for inspections. However, the supply and inventory of homes on the market have recently slowed.
As the Federal Reserve has been increasing interest rates throughout 2022 and will likely continue into 2023, how does this impact the home purchase decision for hopeful homeowners?
It’s common for buyers to look primarily at the price of homes when contemplating whether buying makes sense. While that’s certainly a key element in making an informed decision, I would argue that the monthly expense associated with a mortgage loan is more relevant and meaningful.
Prices are somewhat arbitrary in that they are based on supply and demand. However, monthly expenses are driven by two components when it comes to home buying–the price and the mortgage loan interest rate, which primarily depend on what’s going on in the economy and housing market.
When taking on a mortgage loan, buyers borrow money and agree to pay a stated rate of interest over the life of the loan. At higher real estate values (list prices), a higher interest rate leads to a noticeably higher monthly payment. In contrast, lower interest rates often allow buyers to “afford more house” since the payments are smaller.
Consider the following examples, which illustrate this point:
Wow, a monthly difference of $1,147.85 on an identically priced property! I don’t know about you, but my financial budget would definitely notice a monthly swing of over one thousand dollars. Going one step further, consider the total payments made over the life of these two loan scenarios:
Double-wow! The total amount paid for a $600,000 house costs $413,226 more when the mortgage interest rate is 6% vs. 2.75%. So, what changed in these two scenarios? The $600,000 house is the same house, so we’re comparing apples to apples. The mortgage rate is the key driver and should become a critical component in evaluating the purchase decision.
Let’s assume you’ve done your financial homework and have determined the ideal principal and interest payment for you and your family would be $2,500 per month. Still, a 30-year mortgage rate is 6% in today's market environment. We knew a couple of years ago that you would have been able to afford a $600,000 home, and the monthly payment would fit your budget (as shown in the example above when rates are low). Today, with higher interest rates, the homes you’d need to look at to have a monthly principal and interest payment of $2,500 would be $416,979.
As a financial advisor, I work with our clients to help explain the trade-offs in various financial planning activities, like housing, real estate, and debt considerations being only a few examples. To start clarifying your financial picture, you can read our Getting Organized Guide or learn more about our team.