The rising interest rates are impacting most home buyers’ ability to afford the type of house or condo they expected to be able to purchase just a few months ago. The Fed wants to curb all spending, including home buying, and it seems to be working – rising interest rates are having a dampening effect on real estate sales.

Rising interest rates – hypothetical condo buyer

Let’s say a home buyer needs a mortgage of $800,000 to purchase the desired condominium or townhouse, 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 5% to about 5.5% is fairly typical, but some online lenders are advertising 4% and 6% or 6.5% rates may be just around the corner.

$800,000   for 30 year fixed rate with 20% down at 4% interest – monthly principal & interest payment is $3819.32

$800,000   for 30 year fixed rate with 20% down at 5% interest – payment is $4294.57 (12% more than at 4 %)

$800,000   for 30 year fixed rate with 20% down at 6% interest – payment is $4796.40 (26% more than the cost at 4%)

Today I created a data table showing the payments for principle & interest with ascending rates. I took it as high as 16.50%, which was under the highest average rate in 1981, when some consumers paid more than 18% interest rate on their mortgages. (I remember my mom, a Realtor – Pat Pope – talking about those 18% rates at that time. As I recall, it spurred some sellers into carrying back notes just to get their homes sold.)  When Jim and I bought our first house in 1989, our rate was 10.25% after we bought down the rate by paying 2 points. Hence my strong preference for fixed rate mortgages in recent years, when the concern was the risk of rising rates.

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 $5000 per month, tops?  This buyer is OK up to 6.25%, but cannot qualify at 6.5%.

Mortgage budget of $10,000 per month

Let’s consider a home buyer who can pay $10,000 per month for principle and interest (not including taxes, insurance, or HOA dues, if any).

• At a 4% interest rate and 30 year fixed, the loan amount = $2,094,612 (with 20% down, a purchase price of appx $2,618,000, appx $523,000 down)
• at 5%, the loan amount would be $1,862,816 (assuming same down payment, purchase price could now be no more than appx $2,385,800
• at 6%, the loan amount maxes at  $1,667,916 – the buying power at this point is down 20% from the 4% rate (now the buying power maxes at $2,190,000)

For home buyers who qualified when rates were at 4%, buying right now may be impossible since both home prices and interest rates have gone up. In this case of the buyer who previously could afford about $2.6 million, the buying power at 6% is reduced by about $428,000.

One way to bring the debt to income ratio back into line is to pay points on the loan to buy down the interest rate.

A lender I know, Luis Renteria, just published a YouTube video about how paying points saved a sale when the rising interest rates caused his buyers to get priced out of the market. In his example, the seller paid 3 points to save the sale, which was a lot less than a price reduction which would have had the same impact. Check it out!

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 that it’s really difficult for move up buyers to find it worthwhile to make the move. Most of them have now refinanced to loans with extremely low interest rates, and that will make them even less inclined to move.

If inventory rises significantly, which it may do, and demand is tempered by the rapidly rising interest rates, it will cause prices to fall because supply would outpace demand.

Closed sales are still looking strong, but newly pending sales aren’t so much. The story is unfolding, but it looks like we are going into a correction of some kind. Hopefully it will be mild.

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 mortgage 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 especially those in more remote areas 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 hold or only fall a little. We are overdue for a correction, though, and we will be watching the market carefully.

I do believe that paying points may again play a significant role in home purchases. It will depend on how much bang for the buck consumers can get by doing so.

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. The market is calmer than it was a few months ago – it’s a little bit of a breather right now.

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.

Related reading:

Getting priced out of the market

If it’s in the real estate contract, your lender will ask for it

Selling your home in a shifting market (on popehandy.com)