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Interest rates and affordabilityToday the Fed finally pulled the trigger and set the wheels in motion to increase the cost of borrowing money.  It appears that in 2016 the interest rates will rise between one quarter and one half percent.  What does that mean for Silicon Valley home buyers and sellers, on a practical or budget level?

Let’s say a home buyer needs a mortgage of $500,000 to purchase the desired property (which will sell for $625,000), and that said buyer has good credit and 20% down and is seeking a 30 year fixed rate loan.  Interest rates may vary from one lender to another, but as of right now, a 4% interest rate is pretty typical.

$500,000   for 30 year fixed rate with 20% down at 4% interest – monthly principal & interest payment is $2387.08

$500,000   for 30 year fixed rate with 20% down at 4.25% interest – payment is $2459.70 ($72.62 more than at 4%)

$500,000   for 30 year fixed rate with 20% down at 4.5% interest – payment is $2533.43 (increase of $73.73 per month over the 4.25% rate and $146.35 more than at 4%).

That doesn’t sound too bad – if the rate goes up 1/2 percent in 2016, the additional burden on this hypothetical buyer would be $146.35 per month or $1,756.20 per year. Many in Silicon Valley could absorb that, though they would rather spend their money elsewhere.  But let’s step back and see it more broadly. If the loan is kept for all 30 years, which isn’t so common right now but may become more common if interest rates continue their upward climb, that would be $52,686 more paid over the life of the loan, or more than 10% of the original mortgage amount.

What impact will a rising interest rate have on qualifying for the mortgage?

Now let’s look at this from another perspective.  What if our mythical buyer only qualified for a payment of $2388 per month, tops?  At 4%, that ends up being a $625,000 loan.  How’s the math at 4.25% and 4.5%?

$2388 payment at 4% 30 year fixed = loan amount of $500,193  (80% of $625,241  purchase price)

$2388 payment at 4.25% 30 year fixed = loan amount of $485,425  (80% of $606,781   purchase price, or if they put the whole $125,000 down still, a purchase price of $610,425)

$2388 payment at 4.5% 30 year fixed = loan amount of $471,298  (80% of $589,122   purchase price, or if they put the full $125k down, $596,298)

If interest rates go up 1/2 of 1 percent, this home buyer’s purchase power decreases by $28,943 and that’s only if the buyer is then willing to put $125,000 down, which at that point is more than 20% down.  That’s about 5% of the total initially targeted purchase price, at best!

And if interest rates continue climbing in 2016 and 2017 and into the 2020 decade?  Here’s a look at what happens to payments on a $400,000 loan.

 

30 year fixed rate payments with various interest rates

30 year fixed rate payments with various interest rates

Won’t home prices have to come down to make up for this burden on buyers?

In a balanced market, an increase in interest rates will very often cause a softening of home prices.  In Silicon Valley, we don’t have a balanced market.  We have a shortage of housing which is chronic and there’s no end in sight due to massive hiring, tax laws that de-motivate long term sellers from selling, and so much appreciation in the last couple of years (30%, appx) that it’s really difficult for move up buyers to find it worthwhile to make the move.

Given the extreme shortage of housing in relation to the demand, this increase in rates may dampen appreciation but is unlikely, in my opinion, to cause prices to move downward in most areas and most pricing tiers.  Homes with the best locations (read: short commute, quality public schools, expensive price tag) will probably feel it the least, if at all.  High end home buyers are less dependent on mortage money, so the impact there may be very slight or perhaps nonexistent. Home buyers with less than 20% down, with poor credit, or first time home buyers purchasing at entry levels – and expecially those in more remote areas like South County, Tracy, Hollister, etc. – will likely be impacted by this the most.   I believe that as long as demand is strong and there are enough highly paid people to purchase homes here, prices will probably continue to rise, if less than in the last 2 years.

If that does happen, if prices do continue to go up, the affordability gap will be even worse than what was laid out above.

Some Silicon Valley real estate advice

Home buyers: if you are ready to get into a home you own, rather than to pay someone else’s mortgage as a renter, I’d like to suggest that moving on this sooner is better than later.  Know that interest rates are usually not locked for more than 30 days and some lenders will charge you for a rate lock. If the escrow is delayed, are you at risk of rates going up and your qualifying for the loan evaporating? Make sure to talk with your buyer’s agent and your lender to protect your position as much as possible.

Home sellers: your ideal home buyer may be someone who gets caught being impacted in the cross hairs of rising home prices and rising interest rates, a double whammy!  This is even more acute if interest rates happen to rise when your home is under contract and suddenly there’s a qualification problem.  DO talk with your Realtor about having a backup plan should your home’s buyer’s hit this bump in the road.  It’s not the first time we’ve been to this rodeo, and your agent should help you to plan out some “what if” options.

Check out what’s happening in the Santa Clara County market in the map below: