When it comes to buying a home, interest rates play a significant role in the affordability of the purchase. The interest rate is the percentage charged by a lender for borrowing money. It can vary based on several factors, including economic conditions, credit score, and the type of loan. In this blog, we’ll explore how interest rates impact home buying and what you need to know before purchasing.
Federal Funds Rate and Bank Prime Rate
The Federal Funds Rate is the interest rate banks charge each other for overnight loans to meet their reserve requirements. The Federal Reserve sets this rate, and it is used to control inflation and stabilize the economy. When the Federal Reserve raises the federal funds rate, it becomes more expensive for banks to borrow money, which can lead to higher interest rates for consumers.
The Bank Prime Rate is the interest rate banks charge their most creditworthy customers for loans. It is typically set at a few percentage points above the federal funds rate and is used as a benchmark for other loans, including mortgages. When the Federal Reserve raises the federal funds rate, the bank prime rate typically follows suit.
Current (02/24/23) Fed Funds Rate: 4.75% (Bankrate)
Current (02/02/23) Bank Primate Rate: 7.75% (JPMorgan)
Higher Interest Rates Increase Debt Service
Debt service refers to the amount of money required to pay back a loan, including the principal and interest. When interest rates rise, the debt service on a loan increases, which can impact the affordability of a home purchase. For example, a $300,000 mortgage with a 30-year term and a 4% interest rate would have a monthly payment of $1,430. If the interest rate increased to 5%, the monthly payment would jump to $1,610, an increase of $180 per month or over $64,000 over the life of the loan.
The Impact of Higher Interest Rates on Home Affordability
A higher interest rate means you will need to pay more each month for your mortgage, which can reduce the amount of money you have available for other expenses. Additionally, the higher interest rate may impact the price of the home you can afford.
For example, if you are pre-approved for a mortgage with a 4% interest rate, and that home is $310,000. However, if interest rates rise to 5%, the price of the home you can afford may drop to $275,000. This is because the higher interest rate increases the debt service, which reduces the amount of money you have available for principal and the total amount you can borrow.
Yes, we included this twice because it’s important!
Interest rates play a large role in home buying, impacting the affordability of the purchase and the price of the home you can afford. It’s important to understand how interest rates work and how they impact your monthly payments and overall debt service. Before making a home purchase, be sure to shop around for the best interest rates and consider the impact that rising rates may have on your finances. This blog is a follow-up to a previous blog posted several months ago. What do rising interest rates mean for buying a home?