The Real Costs of Rising Interest Rates for Homebuyers
Key points:
- For most of the past three decades, mortgage rates have declined. But over the next several years, they are projected to increase modestly.
- As rates rise, new home buyers will confront higher financing costs and monthly mortgage payments. For many, this will mean tightening their budgets and sacrificing some luxuries they may take for granted today.
- If rates rise by 1 percentage point, monthly mortgage payments will increase between $710 (San Jose) and $65 (St. Louis).
“Should I buy a home now, or should I wait until next year?”
We get this question a lot, and the only easy answer is “it depends.” Buyers choose the right time to purchase a home based on any number of personal factors, and nobody should ever feel compelled to buy until they’re comfortable with all the commitments involved. Still, there is one thing that’s certain: As both home values and mortgage interest rates rise, monthly mortgage payments for potential home buyers will also go up. But by how much?
We examined how a 1 percentage point rise in mortgage rates would impact monthly payments for the typical home in 35 metro areas, and found that the difference this year versus next year varies dramatically from market to market. In the San Jose/Silicon Valley area, for example, potential buyers should expect to see a monthly payment increase of more than $700 if they waited a year to buy the same home they were considering today. By contrast, in St. Louis, the difference is only $65 per month.
But what do these increases mean to the typical buyer’s monthly household budget?
What the past tells us about the future
Over the past three decades, interest rates have generally trended downward. The typical 30-year fixed mortgage rate has increased for more than four consecutive quarters only once since 1980. As a result, homeowners looking to move would typically encounter substantially lower monthly mortgage costs. Homeowners could either invest that difference into a larger, more expensive home, or they could pocket the savings.
This trend is likely to shift in coming years. Mortgage rates hit historic lows in December 2012 and have since risen modestly. It is debatable how much rates will rise over the next year, but they are projected to continue rising as the Federal Reserve Board withdraws its unconventional policies of recent years. At the very least, rates are not expected to continue falling as they have over the past 30 years. As a result, the financing costs associated with buying a home will increase, and new home buyers will have to adjust, likely by cutting back on other expenses.
How we calculated the monthly mortgage payment change
To calculate the monthly mortgage payment change for a home bought one year from now, we first applied the current Zillow Home Value Forecast for next year, and a 1 percentage point increase in interest rates (from 4.1 percent to 5.1 percent). Additionally, we assume that the home buyer holds a 30-year fixed rate mortgage with a 20 percent down payment, the most common structure of home financing.
If both home values and interest rates rise as expected, many new home buyers can expect to pay substantially more in monthly mortgage payments. After accounting for expected increases in home values over the next year, in addition to higher mortgage rates, home buyers in San Jose in mid-2015 can expect mortgage payments to be $710 more per month than a comparable purchase in mid-2014 – about 5 nights in a hotel, more than 13 tanks of gas, 42 large Domino’s pepperoni pizzas or 195 Starbucks Grand Lattes. At the other extreme, new home buyers in the St. Louis area can expect to pay an extra $65 per month after accounting for both higher interest rates and different bottom-line prices – roughly equal to 1.2 tanks of gas, 4 large Domino’s pizzas or 18 Starbucks Grand Lattes.
The map below shows the increase in monthly mortgage payments and product equivalents for each of these metro areas.
What if home values are unchanged a year from now? How would that affect payments?
To answer this question we used the current median home value by metro area and looked at the monthly mortgage payment on a 30-year fixed rate loan with an interest rate of 5.1 percent versus 4.1 percent.
Households in expensive areas will experience the largest increase in monthly payments due to rising interest rates alone. For example, even if home prices remain constant, the median home buyer in San Jose can expect his or her monthly mortgage payment to be $383 more next year than it would have been today as interest rates rise – equivalent to about 3 nights in a hotel room, 7 tanks of gas, 23 large Domino’s pepperoni pizzas or 105 Starbucks Grande Lattes per month.[1] By contrast, home buyers in Detroit will see monthly payments increase $53 – about 1 tank of gas, 3 Domino’s pizzas or 14 Starbucks Grand Lattes.
The map below shows the increase in monthly mortgage payments new home buyers can expect in a year, how that increase translates into common household expenses and the share of the overall increase that is attributable to rising interest rates alone (as opposed to higher home values).
Where will rising interest rates have the largest direct impact?
Across the 35 metro areas covered by this analysis, about 78 percent of the expected increase in monthly mortgage payments over the next year is attributable to rising interest rates, rather than increasing home values. In places where home values are rising rapidly, such as coastal California, about half of the anticipated increase in monthly mortgage payments is due to rising interest rates. In markets where home values are projected to decline – including Baltimore, Minneapolis, Chicago and Houston – higher costs because of higher interest rates will be offset somewhat by lower overall home prices.
[1] We assume that a tank of regular gas costs $3.63 (the national average on July 11, 2014 according to AAA’s Daily Fuel Gauge Report) and that the typical fuel capacity of a car is 15 gallons; we also assume that a large Domino’s pepperoni pizza costs $17 and that a Starbucks grande latte costs $3.65. For the average hotel room price, we use the Hotels.com December 2013 Hotel Price Index, reported as $131.