Dax’s Data: The True Cost of Changing Interest Rates

Dax Nollenberger
- Dax Nollenberger

Dax’s Data: The True Cost of Changing Interest Rates

With all this talk about inflation and the inevitable increase in interest rates coming in 2022, I wanted to dive into the actual effect that interest rates have on both your buying power and the overall cost of the loan. Now, the two obvious conclusions are that as interest rates increase, buying power decreases and the cost of the loan gets more expensive. But at what rate? And at what impact to the affordability of homes?

Low-interest rates have been a major talking point as to why the real estate market has seen such incredible gains over the last 18+ months. The impact is truly significant. When money is cheaper to borrow, buyers can afford more home. And let me tell you, there are a LOT of qualified buyers in our coastal market. 

So, how much does a 1% increase in interest rates have on the affordability of a loan? The numbers may shock you. Let’s look at a simplistic example: A $1,000,000 loan with a fixed rate for a term of 30 years. Right now, we aren’t going to look at the entire mortgage payment that consists of Principle, Interest, Taxes, and Insurance (PITI) and instead focus strictly on the impact of interest rates on the overall cost. The formula used does calculate Annual Percentage Rate (APR) and therefore reflects a more realistic payment as it includes the interest rate, points, and fees charged by the lender. 

Let’s dive in: 

Let’s first focus on the changes in the affordability of a loan when going from 3% to 4%. The monthly payment jumps from $4216.04 to $4,774.15. An increase of $588.11 (13.24%). That increase, over 30 years, has a serious impact on the overall interest paid on the loan. At 3%, the total interest paid is $517.8k. At 4%, the total interest paid is $718.7k. That means, on a million-dollar loan, if the interest rate increased by 1%, the cost of the loan increases by $200.9k! If it were a $1.5MM loan, a 1% increase in the interest rate would result in an increase of $301.4k in total interest paid. If interest rates hit 5.00%, you would almost be paying double what you borrowed over 30 years. 

Q. So, why are so many buyers eager to purchase when the market is at an all-time high?

A. It is so much cheaper to borrow money right now. Let’s walk through a hypothetical scenario for further clarity: a buyer decides that the market is far too rich and they want to “wait for a year until the market cools down”. The Fed starts to get concerned over the heat of the market and decides to increase interest rates causing a new mortgage rate of 4%. This does have the benefit of decreasing overall buying power for those in the market, creating a leveling off of pricing and decreasing the median price by 5% (unlikely given lack of supply). All of a sudden, that comparable $1.3MM house that the buyer had their eye on is going for $1.235MM. The buyer is ecstatic saying “I was right! I’m going to get this home for 65k less than last year!” For simplicity’s sake, we’ll say the buyer qualified for a million-dollar loan each time. 

The question is, did the buyer make the right decision to wait? 

Let’s break it down:

As you can see, since the buyer waited, they will pay $136k more over the life of the loan! Of course, refinancing at a later date is an option but the conclusion from this data is that interest rates have a powerful impact on the overall cost. Many buyers understand the long-term value of locking in their low-interest rates now. 

It’s not just cost that is impacted by increasing interest rates; it’s also the borrower’s purchasing power. Lenders will determine how much you qualify for but a good exercise is to understand monthly payments and set an amount that you are willing and able to pay. For this example, we’ll set the monthly payment (excluding taxes and insurance) at $5,000. 

As you can see from the chart, the impact of interest rates is significant. Just look at what a spike from 3% to 4% does for purchase power. The amount the buyer qualifies for dips from $1.19MM to $1.05MM, a decrease of $138.6k (-13.24%). The purchase price the buyer can afford drops from $1.48MM to $1.31MM. A decrease in purchase power of $173.3k. 

In Conclusion, low-interest rates have a serious impact on the purchasing power of prospective buyers. A 1% increase in interest rates decreases a buyer’s purchasing power by 13.24%. That 1% increase also has a huge impact on total interest paid; for a $1MM loan, a borrower will pay over 200k more over the lifetime of the loan.  With interest rates at a record low, buyers can afford more. When buyers can afford more, it has significant upward pressure on pricing. 

Once interest rates begin to rise, it will likely have a positive impact on the purchase price ↓ (from a buyer’s perspective). However, as the data shows, that doesn’t necessarily mean it’s more affordable. 

Thanks for reading. Please reach out for all your real estate needs: 831-227-5847. 

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