Rising mortgage rates are on my mind as a potential home buyer. When we first started looking for a home last year, rates were below 4%. Since then, they’ve risen to an average of 4.25% as of last week and have continued to rise this week.

This doesn’t mean that rates will continue to rise. Rates have a tendency to move up and down rather quickly as evidenced by the graph below. Recent fed actions have taken the rates higher.

The possibility exists that this doesn’t change anytime soon if the solid economic news is any indication.

Mortgage rates are loosely tied to the 10 yr treasury rate and that has been creeping up. That’s mainly driven by recent fed actions. They’ve taken a policy of raising the short-term fed funds rate and have begun unwinding their bond portfolio. The end of quantitative easing in the form of tightening has sent the rates up.

Rates going up are usually a sign of a good economy and may seem like great news but often those rates can have a negative impact on a variety of things. The recent volatility in the stock market has shown that the market isn’t sure what to make of the rising rates. A solid economy is good but it may turn around if rates keep rising and demand for goods drops. The problem is that rising rates especially without corresponding income increases lead to higher payments.

Higher payments are not great news for anyone looking to buy a home. That’s also potentially not great news for anyone looking to sell a home.

There are two direct impacts of rising interest rates. Mortgage rates drive your monthly payment. That means even small bumps in interest rates can mean a big increase in the lifetime cost of the loan. The second impact is that higher rates may mean lower home prices for those looking to sell their home.

It’s important to put these rates in a historical context. A 4.25% average rate is still well below historical averages. Still, rising mortgage rates will impact your home search. The affordability and home values might change and it’s important to keep that in mind.

I wanted to take a look at where a mortgage payment might go if this trend continues or if it reverses. At the same time, I wanted to see the impact this may have to home prices if this is the new normal.

Interest rates and mortgage payments

I took a look at various interest rates for 30 year mortgages. The emphasis is placed on 4.25% which is the best rate a borrower with good credit can get today. A higher rate means a higher payment but it’s important to know the actual impact of any rate changes.

Someone taking out a $100,000 mortgage would see their payment go up ~$15 for every .25% move in rates. That may not seem like a ton but it can add up to a lot over the 30 year span of the mortgage.

The difference is even higher as the mortgage gets larger. Someone taking a $300,000 mortgage would see their $1475.82 monthly payment go to $1520.06 if the rate moves from 4.25% to 4.5%. That same mortgage payment would become $1610.46 if the rate rises to 5%. That’s a $150 difference every month and can easily price certain people out of a home.

Naturally, the opposite is true. Rising mortgage rates mean higher monthly payments so declining rates mean lower monthly payments. A buyer who can get a 4.00% interest rate on a $300,000 mortgage would see their monthly payment reduced by $43 against a 4.25% rate.

You can use the table above and your expected mortgage amount to figure out what rising or falling rates could mean to your mortgage payment. Do note that the table above is just your mortgage payment. It doesn’t include additional costs like PMI, property taxes or insurance that may increase your overall payment.

The reality is that $15 a month isn’t likely to prevent you from buying a home but higher values might. It’s also important to remember that this is a very long term commitment. Even a small change in monthly payment can have a huge impact on the lifetime cost of your loan.

The lifetime cost of a mortgage

One thing home buyers must remember is that a mortgage is a long term loan. The $15 payment monthly increase may not seem like much but across the lifetime of a mortgage, it’s $5400 more you’ll pay in interest.

The table above outlines the lifetime cost of various mortgages at different mortgage rates.

The bigger the mortgage, the larger the number. The $43 mentioned before when comparing a 4.00% versus a 4.25% interest rate means a difference of nearly $16,000 on the lifetime cost of the loan.

These are some huge numbers and are very meaningful to the affordability of a home. As evidenced recently, interest rates can rise and fall quickly. It’s important to know what that means in terms of the lifetime cost of the loan.

When I first started looking at homes last year, I was approved for a 4% loan without much trouble. The average was below that and some banks were offering rates well below 4%.

At the 4% rate, my monthly payment for a $300,000 mortgage would have been $1432.25 with a lifetime cost of $515.608.52. Now, that same bank is offering a 4.35% rate with the average climbing above 4.25%.

At the 4.35% rate, my monthly payment for the same mortgage would now be $1493.44 with a lifetime cost of $537,636.74. That’s 20k more I’ll have to pay over the lifetime of the loan if I buy a house for the same cost as before.

That’s a big change and one I’m not too happy about.

Just like before, you can use the table above to figure out the lifetime cost of a mortgage at various rates and mortgage totals.

We’ve figured out that rising mortgage rates mean higher payments. That’s not great and not a plus for buyers. However, there can be another element to consider and that’s what rising rates mean for prices.

Rising interest rate and home prices

One thing that may make potential buyers happy is that rising rates MAY have an inverse relationship to home prices. This means that as mortgage rates rise, home prices MAY drop. I put the emphasis on the worse as that’s not always the case.

The idea is that rising rates mean higher payments. Higher payments lead to less demand for homes at various price points. That lower demand means that certain sellers in certain areas may need to lower prices to match the new level of demand.

If that does happen then your monthly payment may not increase much despite the change in rates.

Imagine you looked at a house that required a 300k mortgage when rates where at 4.25% but rates have gone up to 5% leading to a 25k drop in price. Your 300k mortgage at 4% would mean a monthly payment of $1475.82. However, now that prices are lower, you only have to take out a 275k mortgage at 5% for a monthly payment of $1476.26.

Does that mean house prices are guaranteed to drop now that rates are rising?

No, not always, this is a simplified way of looking at it but it can hold true at times.

The reality is a bit more complicated.

Home prices have a lot of variables that affect prices. Mortgage rates are one as they drive demand. However, they may also have no impact on prices in areas where demand is already super high and supply is low. In a hot market housing market like Denver where 100s of people show up on Day 1 of an open house, there may be little reduction in price.

Certain price points and houses may also have more willing buyers who aren’t too concerned with monthly payment fluctuations. There’s various other local factors that can affect prices in your area. One also has to remember that rising interest rates are generally due to a robust economy. If salaries go up in tandem with rising rates then that gain can lift all boats including home prices.

However, I do think that even if it’s simplified and not applicable to every town in USA, it does hold true in many areas. That means that higher rates MAY lead to lower prices in your area.

As always, potential home buyers have a comparison to make in whether or not it makes sense to rent or buy. That comparison gets less favorable towards housing when interest rates rise and the cost of the mortgage increases. That comparison gets even less favorable when rising rates don’t come with an accompanying reduction in prices of homes.

One excellent tool that buyers should use is this NYTimes calculator. I already talked about how the monthly and lifetime costs can change with rising and falling rates. This tool can help you compare how the math behind buying a home versus renting can change when rates rise or fall.

Let’s take the $300,000 mortgage I talked about above. Assuming a 20% down payment, that’s a $375,000 home. Let’s say I plan to stay in for 5 years and expect home prices to grow at 3%, rent to grow at 2.5%, the market to grow at 4% and inflation to be at 2%.

At a 4% rate, the equivalent rent is $1607. That means that if I can find an equivalent home for rent at $1607 or lower then it makes more financial sense to rent than to buy.

Let’s say the 4% rate goes to 4.35% and nothing else changes. At that level, the equivalent rent is $1670 meaning that renting is more favorable for longer. Why is that?

It’s because the lifetime cost of the mortgage suddenly went up. Plus, there was no accompanying change in purchase price. That means that now buying a home is a worse deal than it was before. In other words, it’s financially better to buy a 375k home at 4% than at 4.35%. It makes sense that a lower rate would be better since it means a lower payment.

Another way I like to use this tool is to figure out how the value of this home changed with the new interest rate. In other words, how much should I pay for this $375,000 home with a 4.35% rate for it to be financially equivalent to buying it with a 4.00% rate. In order to get back to an equivalent rent of $1607 at a 4.35% rate, the home value needs to drop to $360,000.

I also like to look at theoretical home prices based on the idea of people buying solely on the basis of monthly payment. That’s not how things work but it does give you a general idea of how home prices should react to rising and falling rates if price was the sole driver of demand.

The idea is that a buyer willing to take a $100,000 mortgage at 4.25% is OK paying a monthly payment of $491.94. I wanted to see what might happen to prices if mortgage rates were to rise. In essence if the rates rise to 4.35% and they wanted to keep their monthly payment of $491.94, what would the value of that $100,000 be?

The results are shown below.

You can see that if a buyer is willing to spend $100,000 on a home at 4.25% then all else equal, they’d be able to spend $98,820.46 on a home if they want their payment to remain static with a rate bump to 4.35%.

This ties closely with the affordability measure I talked about above using the NYTimes calculator. If rates goes up, in theory prices should go down if the affordability is to stay the same. It can have a big impact on your ability to afford a home if the payment rises. A $500k home at a 4.25% rate is as affordable as a $458k home with a 5% rate when it comes to monthly payments.

The reverse also holds true if rates begin to fall again and home prices stay static. Affordability swings back into more expensive territory if 4.25% is your starting point. A $500k home looks much like a $531k home if the rate falls to 3.75% from the perspective of the monthly payment.

These are all hypothetical values and changes. They by no means you should always expect home prices to drop if rates rise. Nor, does it work the other way around.

It does mean that looking at tables like this can give a potential home buyer some guidance. The impact of rising or falling rates on your mortgage payment is clear. Rising rates aren’t always a bad thing for the economy. Still, from a home buyer’s perspective, they do mean higher monthly payments and lifetime costs of a mortgage. They also make the comparison against renting more hazy.

The positive is that they can also mean lower home prices for potential buyers. That’s due to potential lower demand as mortgage payments rise and price certain people out of home ownership. That’s not great news for sellers but it all depends on your local markets. High demand markets may see no impact and the fact that rates are still historically low despite recent bumps mean we likely won’t see a huge move in home prices in the near term.

Will the rates keep rising?

The path of rates is hard to gauge as evidenced by the graph at the start of this post. Just like the stock market, rates are hard to predict and can turn on a dime.

Buyers have to remember that home prices are impossible to gauge too. They may move in reverse of mortgage rates or they can keep rising if demand remains high.

We saw a similar uptrend at the start of last year. It reversed later in the year but never touched the lows of 2016. It’s hard to tell where the same will happen this year or if rates will keep rising. If the recent policy of the fed has been to raise the fed fund rates and shrink their bond portfolio. If that continues throughout 2018 then mortgage rates will likely continue to rise. The recent stock market volatility may mean they take a less aggressive approach with unwinding their balance sheet. That would lead to moderating rates but just like with the stock market, timing rate changes isn’t easy so it’s hard to predict where we go from here.

My suggestion and the one I’m following is to try to ignore the short term rate movements. What’s important is paying attention to the financial impact and the overall affordability of a home.

Mortgage rates will move up and down but so will home prices. What’s important is keeping the whole picture in mind. It’s easy to look up today’s rates. It’s harder to gauge where they’re going or how your own market will respond to changes in those rates.

If you’re buying a home in a month and have to use today’s rates then it won’t help you if home prices begin to respond to higher rates in the form of lower prices half a year from now. What matters is whether the purchase today is a sound financial decision versus renting and whether it’s the right house for your needs.

The latter part is easy but figuring out the financial decision aspect can be harder. It’s important to be aware of the impact rising and falling rates may have on your ability to purchase a home. There’s a possibility that rising rates may push potential buyers out of certain price ranges. It’s also quite possible that rising rates without an accompanied reduction in price may make the decision to buy a home less financially sound.

At the end of the day, you have two options for housing; rent or buy. It’s important to look at both options and gauge the financial impact of both decisions. Mortgage rates and home prices are a huge part of that impact. That’s why I think it’s important to keep these numbers in mind.

I think buying a home is a good idea if you plan to stay in an area for a long time. It allows you to build equity and insulates you more against rent inflation. There’s also the pride of ownership and freedom that comes with being a home owner. There’s a lot of others things that are hard to quantify. Some benefit home ownership and others benefit renting.

It’s not just a numbers game. Still, since it’s one of the most important purchases of your life, numbers do matter. Rising interest rates can certainly affect those numbers in a big way as I’ve shown here.

I’m currently a renter as are all of those who don’t own their own home. Buying a home is often an emotional decision but I also want to make sure it’s a financially sound decision as well. That’s why I think reviewing data like this is helpful. It’s always important to make sure you’re buying something you can afford and something that makes financial sense.

If I can rent at a much more affordable rate because interest rates have soared in recent months then maybe it’s not the right time to buy. As with any decision, there’s plenty of question marks around everything. For example, my rent could go up by more than expected and shave off any savings rent may afford.

At the end of the day, there’s more to home ownership that just the question of whether it makes financial sense but that question is an important one nonetheless.

That’s why it’s important to keep an eye on interest rates and use some of the data I provided to see if the changing tides there have affected your ability to afford a home.

As for us, right now we’re still looking. We haven’t found anything we loved but the rising rates certainly make me more wary about the prices we’re seeing. We happen to live in a market where renting isn’t that much cheaper than home ownership. Unfortunately, that doesn’t mean houses are cheap, it just means that everything is expensive. That leads me to believe that as long as rates don’t soar too much and we can find the right home at a reasonable price, the financial assessment will likely make being a home owner the smarter financial play.

For others, it may not be as simple.