Lower Rates for First Time HomeBuyers Isn’t What It’s Cracked Up to Be

by David@MoneyNing.com · 2 comments


Americans have been cheering on low rates for years. This is especially true for those looking to buy a home or thinking of getting a bigger home. After all, lower rates lower the interest you pay on a mortgage and reduces the monthly burden. Plus, lower rates increase home values, and that makes just about everybody who owns a home happy.

Lower rates, it’s the best thing since sliced bread. Or is it? I’ve been telling people that a lower rate isn’t as big of a benefit as people looking to buy a home think it is, but that was when rates go up and down a quarter percentage at a time. Does anything change with rates dropping from 4% to 3% practically overnight? How do lower rates change how much house you can afford when rates change so dramatically all of a sudden? Let’s take a look today. I’m interested to make the calculations myself and find out too.

On the surface, lower rates are always good because no one says no to paying less every month. However, a lower rate brings more buyers in and more demand means a higher price. Let’s take a look at how much of a difference these numbers make.

In our example, we will assume that a couple is trying to buy a home with a mortgage of $500,000. With a 4% 30-year fixed mortgage, the monthly payment is $2,387.08. If rates drop to 3%, that 30-year mortgage only costs $2,108.02 each month. Hooray! But here’s the wrinkle. We know that home prices will rise, so how much will the house value have to rise for affordability to become a wash?

With the rates now at 3%, the original monthly payment of $2,387.08 will pay for a mortgage of $566,190. In other words, the mortgage will have to rise more than 13% before a lower rate is bad for a potential homeowner.

But wait, there’s more.

So far, we are just talking about mortgage costs without factoring in the down payment. A typical homeowner may buy a house with 20% down, so our example is really illustrating a couple trying to buy a $600,000 home with a $100,000 down payment and a $500,000 mortgage. If mortgage affordability is the same when someone borrows $566,190 once the rate lowers to 3%, then once a home rises more than $666,190, then lower rates are bad. This is a rise of 11%. It still seems like a good deal when rates are lowered this drastically and suddenly.

Now let’s factor in property taxes. We are going to use roughly 2% as this is the norm in my neck of the woods. The $600,000 house is going to cost $12,000 a year in taxes, or $1,000 a month. This makes our original monthly payment with the same down payment $3,387.08 at a 4% interest rate.

If rates drop 3% and house prices rise, your property taxes will go up but your monthly mortgage will go down. Without running you through a pretty complex algebra lesson, the numbers become a wash when the home costs $647,437. This is with the same down payment of $100,000, a mortgage of $547,437 costing $2,308.02 and a property tax of $12,948.74 costing $1,079.06 for a total of $3,387.08.

The math can be hard to follow, but the bottom line is that our couple is better off if house prices rise less than 7.9%.

Housing prices rose 5.5% from a year ago nationally, so it still looks like the average first-time homeowner is ahead due to low rates. It’s not really that much of a benefit though. I mean, we are talking about a 2.4% difference in affordability here. After the mortgage rate was slashed by a shocking 25%, you get to go out for dinner one more time a month. Now, what if rates go down a quarter percent like in normal times?

There are other intangibles that make the calculation even closer.

First of all, you will need to pony up a higher down payment when homes cost more. Notice that in our example, the original $100,000 is below the 20% down payment typically required for homeowners to skip private mortgage insurance (PMI). If you can no longer afford to put even more money on the table, then that break-even calculation swings in the favor of rates not changing even more. For instance, a PMI that costs 2% of the loan lowers the break-even percentage to roughly 6.5%. You will still get to go out to eat once more a month, but you can’t order drinks anymore.

Even if you can come up with more money, losing that amount in liquidity is never a good thing.

Property taxes rise every year, whereas your mortgage payment does not for most who opt for a fixed-rate mortgage. A bigger base means that each increase goes up more every year. This only pushes the calculation even further to favor rates staying the same.

There is less room for refinancing to help your finances in the future. You’ve no doubt heard of stories about how mortgage rates used to be in the double digits. When rates go down, refinancing is a windfall like no other. Even those who owned homes won the mini lottery when rates went from 6% to 4%. In fact, going from 4% to 3% is just as good. But now that the rates are at 3%, there just isn’t that much room for improvement. This is because servicing a mortgage has fixed costs, like the administration of the mortgage as well as the salaries and commissions of those who helped you refinance. As these costs are passed onto the borrower, rates can’t just go to zero.

If you get a mortgage at 3%, you are less likely to benefit from future refinances due to even lower rates.

Bottom Line
People around the world cheer when mortgage rates go lower. Sure, refinancing is hugely beneficial for those who already own a home. But for the rest of the population who wants to get into homeownership, lower rates aren’t really what it’s cracked up to be.

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  • steveark says:

    Good points! We bought the house we still live in 41 years ago with a first time home buyer low income low interest loan. The interest rate was 8.75%! Conventional loans were north of ten percent! What a difference a few decades make. We did eventually refinance before we paid the loan off but I think we never got lower than 6% interest.

    • David@MoneyNing.com says:

      Oh man, I can’t even imagine having to pay for a loan with interest rates in the double digits. The crazy thing is everybody still wanted to buy a house back then!

      It’s no wonder why banks were such a great business back in the day!

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