Here’s How to Afford a Home, Even if Mortgage Rates Jump

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Rising interest rates mean higher monthly payments. That’s a simple, obvious conclusion. Is that dampening enthusiasm for homeownership? According to a recent article in Marketwatch.com, consumer optimism in home prices has almost never been higher, and home prices continue to rise according to the leading home price index, the Case-Shiller report. Why is this?

Homeownership is Still the American Dream

Despite a reputation for being averse to homeownerships, 80 percent of millennials still want to own homes, according to a recent survey by Apartment List. They don’t, however, because they are constrained by economic factors.

If most renters still want to buy homes and believe home prices will continue to rise, and the only factor stopping them is affordability, rising interest rates should affect them. The question is, what can they do about it?

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Rising Mortgage Rates’ Impact on Monthly Payment: How Much Is It, Really?

According to The Balance, the average mortgage in the U.S. in 2017 on a new home purchase was $211,500, so we’ll use that as a benchmark. The Freddie Mac weekly mortgage market survey tells us that as of May 10, 2018, the average interest rate given consumers for the previous week was 4.55 percent for a 30-year fixed mortgage.

For comparison purposes, we need to estimate how high interest rates could go this year. While no one knows for sure, the highly respected Kiplinger Newsletter recently projected that mortgage rates would rise to 4.7 percent this year. Since mortgages are offered in 0.125 percent increments, let’s compare the monthly payment of a $211,500 mortgage at 4.50 percent (current rate) to 4.75 percent (expected rate).

At 4.50 percent, your monthly payment for principal and interest only would be $1,071.64.
At 4.75 percent, your monthly payment for principal and interest only would be $1,103.28.

The difference of $31.64 is equivalent to six lattes, four servings of avocado toast, four cheap lunches or one-half of a nice dinner out. It isn’t zero, but it’s not catastrophic either, and it’s doable if you are committed.

How to Get a Lower Mortgage Payment if You Decide to Wait to Buy

If you don’t like the idea of giving up your lattes, avocado toast or meals out, there are other ways to lower your payment.

Adjustable-Rate Mortgages Might Make Sense

According to the same Freddie Mac weekly survey mentioned above, the average interest rate for a 5/1 ARM (Adjustable-Rate Mortgage) in the same week was 3.77 percent. If we assume an interest rate of 3.75 percent (to adjust to the nearest 0.125 percent increment), the monthly payment would be $979.49, or $92.15 less than a 30-year fixed.

It’s true that the interest rate on this loan could rise in five years, but in the meantime, you would save $5,529, and you would have five years to plan for a refinance or increase your income so that a higher payment would be manageable.

Remember, too, that your interest rate and payment may not go up. The rate could stay the same, and even go down. It just all depends on where interest rates are when the time comes to adjust.

An adjustable-rate mortgage is best for folks who either expect steady, significant increases in their income over the ensuing years or are extremely good at budgeting and saving money. This type of mortgage is not a good option if you can barely afford or qualify for a fixed-rate mortgage, do not expect large increases in your income, do not save well or have very uncertain job security. If you can barely afford the mortgage payment now and don’t have reasonable hopes that you can in the future, it’s not a good idea.

Higher Down Payment = Lower Monthly Payment

Pricing on mortgage loans is very sensitive to Loan-to-Value Ratio (LTV) and credit score. Pricing improves dramatically at certain thresholds. At 80 percent LTV, for instance, you no longer need mortgage insurance. At 75 percent, you get an additional price break on the interest rate. Let’s take a look.

Let’s assume that our $211,500 loan represents 85 percent LTV on our purchase. Keeping the interest rate at 4.50 percent, we find that Principal and Insurance (P&I) would be $1,071.64 (as before) and we would have a monthly mortgage insurance payment of $35.25, for a total payment of $1,106.89.

But if we can find another 5 percent down for a 20 percent down payment, our interest rate is the same, but we save the mortgage insurance: $35.25 more in our pocket each month, just for coming up with another $12,441 for the down payment. But note: This isn’t a cost — it goes straight to equity.

If we can find another 5 percent down, we can shave another 0.125 percent off the interest rate, depending on the day and the lender. This shaves another $76.85 off our monthly payment, for a total savings of $112.10 per month compared to our 15 percent down example. Note that this is far greater savings than a 0.250 percent rise in interest rates would have cost us.
Of course, this is only feasible if you can find the extra money for the larger down payment.

Consider a Buy-Down Mortgage

Do you need a lower payment for the first year or two, but don’t want an adjustable rate? One of my favorite products ever is the buydown. It’s a shame that hardly anyone offers this anymore because it’s an awesome product.

Here’s how it works: You get a 30-year fixed mortgage, with a slight twist. In year one, the interest rate is 2 percent less than the permanent rate, in year two, the rate is 1 percent less, and after that it’s reverts to the regular note rate. How does a lender offer this fantastic deal? He or she charges you the difference in the payment up-front. (So, I’m sorry but it’s not free money.)

How much does this cost? On our $211,500 mortgage at 4.5 percent, the rate would be 2.5 percent the first year and 3.5 percent in year two. The additional up-front cost of this would be about $4,300.

You could come up with this money yourself, have the seller pay for it as a credit (in a buyer’s market) or have the lender pay for it by raising the permanent interest rate. How does that work? Every lender can — and should — offer you the choice to trade off up-front costs against the interest rate. You can pay a little more in points for a lower interest rate or save up-front costs by accepting a higher interest rate.

How much higher would your interest rate be to pay for your buy-down? Today, this would mean an increase in the interest rate of 0.375 percent to 0.500 percent, depending on the lender. So, you could get a buydown mortgage at 3.000 percent in year one, 4.000 percent in year two and 5.000 percent in years three to 30, for about the same initial cost as a 30-year fixed at 4.500 percent.

This is an excellent choice for a home buyer who likes the idea of an adjustable-rate loan but prefers to know (and plan for) what his or her interest rate will be for the life of the loan.

Lender-Paid Mortgage Insurance

Have you ever seen or heard ads where a lender says, “We pay the mortgage insurance so you don’t have to!”? You probably thought, “Wow, those are really nice folks!” Or maybe you figured that there was a catch, and there is. But it still might be a useful strategy, so let’s look at it.

Why do you need mortgage insurance in the first place? Statistically, the less you put down on a home the more likely you are to default on your mortgage. Even if you are able to catch up and avoid foreclosure, you become much more expensive for the lender to work with.

Lenders, therefore, require that you carry mortgage insurance so that if they foreclose and lose money, the insurance company will reimburse them for some or all of their loss of principal.

Looking above at our earlier example, we’ll assume a $211,500 loan again, with an interest rate of 4.50 percent. Your monthly payment (principal and interest only) would be $1,071.64. Mortgage insurance would add another $35.25, for a total payment of $1,106.89.

What if we decided to “have the lender pay for mortgage insurance?” Today, the same loan would run 0.125 percent higher in interest rate at the same cost. (This varies, but it’s representative.)

A $211,500, 30-year mortgage at 4.625 percent would require payments of $1,087.41, $15.77 more than the principal and interest payment with borrower-paid mortgage insurance, but $19.48 less than principal plus interest plus mortgage insurance.

You can choose to pay $35.25 extra per month for mortgage insurance, or $15.77 more per month in your mortgage payment.

This may not seem like a huge difference, but sometimes all it takes is a few dollars to help you qualify for the mortgage. Moreover, using lender-paid mortgage insurance would save you $1,169 over the next five years.

Why wouldn’t everyone do this? Well, remember that once your loan-to-value ratio is less than 80 percent, you can get rid of mortgage insurance, but the higher interest rate for lender-paid mortgage insurance lasts for the life of the loan. You will always pay the higher interest rate with lender-paid mortgage insurance until you pay off the loan or refinance.

Let’s compare our options:

Standard 5/1 ARM Higher Down Payment Buy-down Lender-Paid MI
Loan Amount $211,500 $211,500 $211,500 $211,500 $211,500
Interest Rate 4.500 percent 3.750 percent 4.375 percent 3.000 percent 4.625 percent
Payment $1,071.64 $979.49 $1,055.99 $891.69 $1,087.41
MI $35.25 $44.06* $0 $35.25 $0
Total Payment $1,106.89 $1,023.55 $1,055.99 $926.94 $1,087.41
Notes You can eliminate MI when LTV < 80 percent Interest rate will begin to adjust after five years Requires 25 percent down payment to eliminate MI and reduce rate Interest rate rises to 4 percent in year two, 5 percent in years three to 30 You can refinance to lower rate in the future

Counteracting Increasing Interest Rates: What is the Best Strategy for You?

It depends – on your circumstances and concerns. The important thing is that while you can’t control where interest rates are, you do have several options for dealing with rising interest rates. Don’t let them stop you from becoming a homeowner.

*The mortgage insurance for adjustable-rate mortgages is slightly higher than for fixed-rate mortgages.