I recently discussed the historically low interest rates we currently experience and how, from a leverage cost perspective, this is a wonderful time to be a buyer of real estate (not to mention all that inventory to choose from). I promised a follow up article to actually illustrate the impact small changes in interest rates have on a buyer’s purchasing power. So here it is.
The spreadsheet to the left (click the image to see a full size version) provides a simple illustration of the impact interest rates (even small changes) have on a buyer’s capacity to buy. The top half of the spreadsheet illustrates the recent median sold price points for several communities here in Davis County. I then did a very simple principal and interest payment calculation based on a 3.5% down payment (common FHA requirement) and a 30-year term based on various fixed interest rate levels. (Quick disclaimer here: I am not a mortgage broker, do not play one on TV, and did not stay at a Holiday Inn Express last night).
You will note the variances in the monthly principal and interest payments at different interest rate levels. Many of the incremental changes don’t appear to be all that significant. However, this brings us to the lower table.
The lower table roughly translates the principal & interest payments into a corresponding "qualifying income." Please again refer to my disclaimer in paragraph two. In order to calculate this rough estimate, I utilized a broad FHA underwriting guideline which uses a 29% mortgage payment to effective income ratio. FHA also goes on to define a mortgage payment as comprising several items including principal, interest, property taxes and insurance (PITI) as well as any mortgage insurance that may be required. So for this illustration, the mortgage payment is calculated to include the principal and interest amount from the upper table as well as a monthly property tax and insurance component (estimated at 1.1% of the median price divided by 12) as well as a mortgage insurance premium (estimated at 0.9% of the loan amount).
Throw all those calculations together and you see the results in the lower table. Please note underwriting standards vary considerably and involve many different components including credit scores, other debt levels, down payment, etc (did I mention my disclaimer?). What this table illustrates is the effect increasing interest rates have income required to qualify for a mortgage loan. This directly translates to the price point of the home you may wish to purchase. Common sense? Of course. But, many people don’t fully appreciate the impact of interest rate increases - most focus on the monthly payment amount and don’t relate it to the income they need in order to simply get past the initial underwriting requirements.
As a simple example, a potential buyer has a family income of say $70,000 and the current interest rate is near 4.5%, they pass the initial income qualification for that wonderful median priced home in Farmington (with the cute yard and wonderful master bedroom suite). However, in the course of looking at other homes (just to make sure all the potential options are explored), interest rates creep up to 5.5%. Assuming this buyer didn’t get a recent raise or a higher paying job, that home is now outside their price range (of course, they could put more money down to make the numbers work).
Going back to my original post a few days ago which initiated this analysis, there will be a tendency for many buyers to watch as interest rates rise but stay at very attractive levels (5.5% or even 6% are still good rates historically) but that rise could just as easily move them out of the home they really want. The opportunity cost of inaction can be quite large.
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