The Real Cost of a Change in Interest Rates

Everyone knows that a projected rise in interest rates is a concern for both buyers and sellers in the housing market. But what is the real, hard cost of each increase, and what does it mean to the buyer and seller?

The real cost is dependent upon the amount of increase (or projected increase), the size of the mortgage, and the length of time the owner is expected to hold the mortgage, their tax rate, and the investment opportunity loss of paying a higher monthly mortgage payment.

For the purpose of illustration, lets take a look at a typical mid-high end Greater Boston purchase. $1,000,000 purchase, 25% down, $750,000 mortgage. We will look at interest rates ranging from 6% to 7.5%, in increments of one half percent.

Interest Rate 6.00% 6.50% 7.00% 7.50%
Payment $4,497 $4,741 $4,990 $5,244
5 Year Total 269,798 284,431 299,386 314,647
10 Year Total 539,595 568,861 598,772 629,293
20 Year Total 1,079,191 1,137,722 1,197,544 1,258,586
30 Year Total 1,618,786 1,706,584 1,796,317 1,887,879

5 Year Difference 14,633 29,588 44,849
10 Year Difference 29,266 59,177 89,698
20 Year Difference 58,531 118,354 179,395
30 Year Difference 87,797 177,530 269,093

Present Value (6%)
5 Year Difference 12,615 25,508 38,664
10 Year Difference 21,967 44,419 67,328
20 Year Difference 34,041 68,833 104,334
30 Year Difference 40,677 82,252 124,673

The table above shows a simple exhibit of change in monthly payments at the various interest rates, as well as the total payments over a 5, 10 20 and 30 year period. It also shows the difference in total additional payments over the same time frame. Since there is a time value of money, we have to discount those additional payments. I have used 6%, which is conservative compared to historical stock market returns. It also helps offset not including the tax benefit of additional interest payments.

The effect of potential interest rate increases that both buyers and sellers need to consider is twofold. First is affordability and mortgage qualifying, as important debt to income ratio's increase. The second and more important is the present value of the cumulative effects of the additional payments. I call this purchasing power.

Under the above scenario, a half point increase in rate is the equivalent of paying almost $13,000 more for the home if the mortgage is held for 5 years, $22,000 if held for 10 years, and $41,000 if held for 30 Years. A full point increase would result in loss of purchasing power of $25,000, $44,000, and $69,000 over a the same time frames. Another way of looking at the analysis is that for a typical 25% down mortgage, the buyer stands to lose purchasing power of 1.2% to 4% for every half % increase in rate, depending upon the amount of time they hold the mortgage.

Buyers should be aware of potential loss of purchasing power while they await "home prices to fall" before making offers, or negotiating price with sellers. Sellers should be aware when deciding what price to put their house on the market, re-pricing, and negotiating with buyers.