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.

Are Interest Only Mortgages Getting a Bad Rap?

There has been a plethora of newspaper articles, television reports and radio discussions over the last several months condemning interest only loans. I have even had clients reject interest only products out of hand because they "heard interest only loans were bad". But are they really?

The "experts" who criticize interest only products cite the fact that most interest only mortgages are tied to variable rate programs. In the current environment of rising interest rates, the borrowers may face substantial increases in their monthly payment if the fixed rate period of the mortgage ends and they begin amortizing the loan. The experts fail to mention the substantial savings the borrowers had during the fixed period of the loan as compared to getting a longer term loan, or that the borrower can refinance into another interest only loan.

Where the criticism is justified is in those cases where the loan officer knowingly puts a client in an interest only loan as the only way that a client can qualify for the mortgage. Shame on the loan officer. If the loan officer explains all of the nuances and potential future payments and the borrower knows he may not be able to afford the future payments – shame on them as well.

When used correctly, interest only products is one of the most dynamic innovations that have ever come to home financing. Correct utilization is based upon cash flow management – not affordability of the purchase. A hidden gem of these products is that although they lower your "required" monthly payments, they do not restrict you from making payments to principal. But unlike traditional amortizing loans, when you do make extra principal payments, the monthly required payments is recalculated based upon the new balance, whereas the amortizing loans payment never changes. This in effect reduces future monthly payments.

So who benefits most from these loans? Professionals, executives, self-employed, and commissioned sales people. I work with both partners in law firms and executives who earn a minimal monthly draw or salary to cover daily living expenses. These clients need to manage cash flow, and a reduced monthly mortgage payment is very beneficial. They are also awarded a large year end distributions or bonuses - which they use to pay down a significant amount of their mortgage balance – which again reduces the minimum payment for the following year, increasing cash flow.

Commissioned sales people and the self-employed often have income that fluctuates from month to month. For such clients, I set up an amortization schedule over 30 years, 20 years, or whatever they desire, and let them know how much principal they have to pay throughout the year to meet the schedule. On good months they make extra payments, and on difficult months, they make the minimum required payment.
Those with short term outlooks also benefit, as there concern in minimizing monthly payments – not paying off the mortgage. These include builders, renovators, and in some cases, real estate investors.

It's all about Cash Flow!