Small Business Taxes & Management

Special Report

Mortgage Rates on Rise--Effect on Affordability


Small Business Taxes & ManagementTM--Copyright 2013, A/N Group, Inc.


Are interest rates heading up? They've already started moving in that direction. According to one source, average interest rates for a 30-year fixed mortgage have moved from about 4.0% to almost 4.25% in just a few weeks. That's quite a jump and, while there may be another similar bump, it's unlikely they'll keep going up at anywhere near that pace. That would not be good for the economy because it could quickly put a damper on housing. The Fed would surely step in to prevent rates from rising too quickly or too far.


Effect on Housing

But how high they'll go is anyone's guess. They're more than likely to settle near 5%. How long will it take to get there? That's an even more difficult question to answer. One projection shows it taking several years. We've enjoyed a period of abnormally low rates. For the first seven years of this century rates on a 30-year mortgage averaged about 6.5%; lately they've been closer to 4%. According to many projections, rates on shorter-term loans such as car loans, are not likely to move up significantly.

What does this mean for mortgages? Clearly, monthly payments will go up for the same size mortgage, but the impact may not be as much as you might think. Here's a table of your monthly payment on a 30-year and 15-year mortgage based on borrowing of $100,000.

     Interest    30-Year    15-Year
       Rate      Monthly    Monthly

       3.75%    $463.11    $727.22
       4.00      477.42     730.69
       4.25      491.91     752.28
       4.50      506.69     764.99
       4.75      521.65     777.83
       5.00      536.82     790.79
       5.25      552.20     803.88

Example 1-- From the table, the monthly payment (principal plus interest) on a $100,000 mortgage at 4.25% interest would be $491.91. If your mortgage was $300,000, simply multiply that amount by 3 to get $1,475.73 per month.

Example 2-- How much more per month would your payment be if interest rates rose from 4.25% to 4.75%? The difference on a $100,000 mortgage would be $521.65 (4.75% rate) less $491.91 (4.25% rate) or $29.74 per month. On a $300,000 loan, the increased payment at a 4.75% rate would be three times that amount or $89.22. While that's not insignificant, it shouldn't be a deal breaker for most home buyers. Moreover, for most of the U.S., a $300,000 mortgage is on the high side. The median home price for the U.S. is closer to $160,000. Assuming only $10,000 down, the increased payment would be half of the $89.22 or about $45 per month ($540 on an annual basis).

How does this affect how much house you can afford? Underwriters use two ratios--the back-end ratio and the front-end ratio. Both compare your monthly debt service to your monthly income. The back-end ratio takes into account all of your debt service--house payments including principal, interest, real estate taxes and insurance; credit cards; auto loans; etc. The front-end ratio uses only house payments--the mortgage payment, real estate taxes and homeowners insurance. Since we're only concerned with the difference on the your mortgage payment, we'll use the front-end ratio. The front-end ratio is your monthly housing expenses divided by your monthly income. Lenders like to see a ratio of about 30%.

How does that translate into numbers? Unfortunately, the computations here are more complicated. However, let's assume you can just afford a $100,000 mortgage based on your income, a 4.25% interest rate and the front-end ratio of 30%. That means as interest rates go up you the amount of the loan will have to decrease to keep your monthly payments the same if the other variables (your income, real estate taxes, and insurance) remain the same. It turns out you can use $2,900 as a good approximation of the decrease in the amount of loan you can afford for each 1/4 percentage point increase in interest rates.

Example--Fred and Sue were house shopping. Based on their income, a front-end ratio of 30%, and an interest rate of 4.25% they could afford a $100,000 loan. Interest rates rise to 4.5%. The maximum loan they now qualify for is one for about $97,100. If interest rates move to 4.75%, the maximum loan would be about $94,200.

Keep in mind that this is just an approximation, but it'll give you an idea of the magnitude of the effect of an interest rate change on what you can afford to borrow. Looking for a $300,000 loan? Multiply the $2,900 by 3 to get a $8,700 change for each 1/4 percentage point increase.

Some points to keep in mind. First, the front-end ratio isn't the only determinate of the amount of mortgage you'll be able to get. Second, you could find that higher rates aren't your real problem. In some markets buyers are snapping up properties or even bidding up prices. That could prove more costly. And other markets remain soft enough to negotiate a lower price. You may stand a chance of doing so if you're ready to buy, but have to get a $7,500 reduction in price to secure a mortgage. Third, at some point a jump in interest rates will put a damper on the market and constrain prices.

While it's not time to panic, there's no question if you were looking to buy, now would be a good time to move. It's unlikely that prices or interest rates will go lower from this point.


Other Interest Rate Issues

While interest rates on home loans are probably the biggest effect on most individuals because of the dollars involved, rising rates will have effects in many other areas of commerce. Here are some points.

Business loans. While any rise in rates could be more muted than for home mortgages, if you're in the market for a loan, or thinking about refinancing, now is the time to check with your financial advisor. That could also apply to loans to or from a related party such as you business. The IRS Applicable Federal Rates are moving up.

Auto loans. The thinking is that auto loans won't be under the same upward pressure as mortgages. But if you're in the market, it might be best to check rates on a regular basis.

Bonds. Rates will surely be moving up and that means bond prices will be fall. Again, no predictions on how much, but this is not the time to be buying long-term bonds. Stay short to avoid getting stuck with overpriced issues.

Dividend paying stocks. While some dividend paying stocks could be affected by a rise in rates, most will be less sensitive than bonds. Look for stocks that have growth potential along with a history of increasing dividends.


Copyright 2013 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. Articles in this publication are not intended to be used, and cannot be used, for the purpose of avoiding accuracy-related penalties that may be imposed on a taxpayer. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536

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--Last Update 06/21/13