This is an update of an earlier article posted on October 5, 2010.
How much does a lower interest rate on a mortgage reduce the cost of a
home? That sounds like a simple
question. Of course a lower rate means a lower monthly payment. But how much of
a difference does that really make? I’ve
heard people over-simplify the issue by saying that a 1% change in rate is
roughly the same as a 10% change in price. Let’s look into this a little closer
and see if it holds up.
We’ve all heard that interest rates today are at all-time lows. I think we
take that for granted, so it helps to include this chart that goes back to 1971.
It shows a 41-year trend of 30 year fixed mortgage rates. As you can see by the graph, mortgage rates
are near the lowest point that we have seen in our lifetimes.
According to Freddie Mac, average conforming 30 year fixed mortgage rates
are around 4.5% .* If you were to purchase a home with a $350,000 home loan,
the monthly principal and interest payment at that rate would be $1,773.
Now let’s see how raising the rate to the 2000 average of 8.05% affects the
payment. That’s not all that long ago. The payment at same loan amount at the
2000 rate is $2,580. We increased the rate by 3.55% and that resulted in a 45%
increase in payment! That seems worse than the 1% rate to 10% price ratio, but
let’s look at it from a price perspective.
That increase in payment from $1,773 to $2,580 is the same as raising the
loan amount from $350,000 to $509,268. That is also a 45% increase in loan
amount. If the down payment is the same percentage for each example, then it
also results in a 45% increase in sales price.
So for this example we discovered that a 3.55% increase in rate equals a 45%
increase in price. It also means a 1% increase in rate is equivalent to a 13%
increase in sales price.
Don’t think I chose a year with an exceptionally high rate. I could have
used 1981 where rates were 16.63%. In fact, the average rate over the 36 years
is 9%. I chose 2000 because it wasn’t that far back in history. The lesson here
is that even though rates have risen over the past several months, we must
recognize what an amazing opportunity we have to borrow money at this specific
point in history. Years from now we can look at an updated version of this
graph realize what a great deal there was in 2013.
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