Most real estate buyers can’t afford their home. A first time buyer who saves up for a down payment, has good credit still can’t afford their home. Being able to afford their home means paying cash. When a buyer says that they can afford a $300,000 home for example what they actually mean is that their budget allows for them to afford the payment on the mortgage that goes along with a purchase price of $300,000.
When a buyer is in the market for a home the period is usually short enough so that the interest rates on a mortgage are relatively stable. But this is not always the case. For a long time now, interest rates have been historically low. I fear that we are beginning to expect the rates to stay where they are. But at some point, as with all things, interest rates will change. And I hate to be the bearer of bad tidings, but when they change, most likely they will go up. When I broke into the real estate business as a green agent in Boulder Colorado in 1992 8% was a great rate. Now 4% is considered a great rate.
So when interest rates do go up the issue will not be how expensive a house you can afford, it will be how big a payment a buyer can afford. So let’s look at how sensitive a payment is to changes in interest rates. This is called payment elasticity. Let’s consider the following scenario.
- A buyer has been pre-qualified for a mortgage payment (not including taxes or insurance) of $1800 per month. At the current interest rate of 4.5% this translates into a top home price of $355,000.
- They are excited about their home search and on their first time out with their Realtor (call me ) they see some really great homes. They are happy with the type of home they can get but decide to keep looking.
- They have a trip planned and then people coming into town so they are not able to look at homes for a number of weeks. During that time interest rates increase from 4.5% to 5%. The next time out they find a house listed for $355,000 and write an offer for $350,000.
- It gets accepted and everyone is really excited until they talk to their lender who informs them that “interest rates have increased and they can no longer qualify for the house they have a contract on. Their top price range is now $335,000″.
- Crushed! Disappointed! Upset! Betrayed!
It’s called interest rate risk and it can really happen. In my scenario, the buyers lost $20,000 of purchasing power in a short amount of time as interest rates climbed just 1/2%. To see how this looks with real payments take a look at the chart below.