No one likes to hear that interest rates are going up. In most people’s minds, this means higher mortgage payments or a declined mortgage application. While it’s true that rising interest rates have an effect on your mortgage affordability, it’s not the only factor. A lower rate doesn’t necessarily mean it will be easy to afford your loan. In fact, 1/4th or even ½ of a point doesn’t make a huge difference in your payment.
We look at the specifics to help you understand this theory below.
How Can a Lower Interest Rate Help You?
A lower interest rate does one obvious thing – it makes your payment lower. You’ll pay less money towards interest and more towards the principal, which is what you want. After all, you want to pay off your mortgage sooner rather than later, right?
However, a lower rate can also help you buy more house. This goes hand-in-hand with the lower payment. With less interest to pay, you have more room for principal repayment. Assuming you have room in your debt ratio, you might be able to increase your purchase power if you are able to secure a lower rate.
What Does Rising Interest Rates Do?
Rising interest rates have the opposite effect on your ability to get a mortgage. For example, if you apply for a pre-approval today, but don’t find a home for 3 months and rates are higher, you could be in a bind. If you were already at the maximum of what you could afford according to your debt ratio, a higher rate could put you over the edge.
Generally, every 1/4th of a point that a rate increases, you lose about 2.5% of what you can finance. Again, this is only if you are on the brink of the maximum allowed debt ratio.
In reality, though, even a 0.5% higher rate won’t make that much of a difference. For example, let’s look at a $150,000 loan. At a 4% interest rate, you would pay $477 in principal and interest. At a 4.5% rate, you would pay $507 per month. It’s only a difference of $30. But, if your debt ratio is that close to the max, it could make you ineligible.
What’s the Debt Ratio Have to do With It?
Rising interest rates ultimately affect your debt ratio, which is what determines if you can get a loan or not. Understanding the debt ratios for each program can help you see where you need to be:
- Conventional loans – Allow up to a 28% housing ratio and up to a 36% total debt ratio
- FHA loans – Allow a 31% housing ratio and up to a 43% total debt ratio
- VA loans – Allow up to a 43% total debt ratio
- USDA loans – Allow up to a 29% housing ratio and 41% total debt ratio
The housing ratio pertains strictly to the mortgage payment. It includes the principal, interest, real estate taxes, and homeowner’s insurance. It also includes any mortgage insurance you must pay. You’ll have to take that into consideration when choosing a program. For example, on a conventional loan, unless you put 20% down, you’ll pay Private Mortgage Insurance every month. FHA and USDA loans also charge a monthly insurance fee. VA loans are the only loans that don’t charge any type of insurance on a monthly basis.
If your debt ratio is higher than the maximums allowed here, it’s not necessarily an automatic denial, though. It depends on your other factors. Lenders look at your compensating factors too.
What are Compensating Factors?
Sometimes you have one negative aspect of your mortgage application, such as a high debt ratio. But, you may have other favorable qualifications, such as a high credit score or a large amount of assets on hand. Lenders look at this stuff and they call it compensating factors. They look for something to make up for the risk that say your high debt ratio causes. If the compensating factor is enough to offset the risk, you may still be able to secure the loan.
So should you worry about rising mortgage interest rates? You probably should al little bit just because it does affect how much you pay over the life of the loan. You want to minimize your interest payments and focus on the principal that will give you equity in the home. But, if the change is minimal, it’s probably best to focus on what you can afford and work on paying your loan down as best you can.