With housing affordability on the decline, many potential home buyers worry about home prices increasing in their desired area. But one often overlooked factor in that affordability equation is mortgage rates.
High rates can easily price potential buyers out of the market, affecting future wealth accessibility and compounding the housing crisis even further. However, there are ways to mitigate the effect of high or rising interest rates.
The affordability crisis deepens as rate go up
According to the National Association of Home Builders (NAHB), more than 87 million U.S. households are unable to afford a $412,505 home – the median in the country for a new home. Another 9 million were priced out over the last year as mortgage rates rose.
“The monthly mortgage payment has increased by about $500 [in July 2022] since the first week of January when rates were about 3.2%,” said Nadia Evangelous, Senior Economist and Director of Forecasting at the National Association of Realtors.
“Rents are rising fast as well. As a result, potential first-time buyers need to spend more out of pocket on rent, they also need to spend more on mortgage payments if they want to buy a home,” continued Evangelous. “Meanwhile, nearly 20% of the first-time buyers already spent 60% and more of their income on rent. Therefore, rising rents and inflation make it more challenging to save the money needed to make the transition into homeownership for these renters.”
Making matters worse, Freddie Mac reported that the 30-year fixed mortgage rate rose to 6.29% in the second week of September 2022. Accordingly, the monthly mortgage payment for a $400,000 loan is about $2,470 compared to $1,660 a year ago.
3 ways home buyers can counteract higher mortgage rates
Given the higher costs, it might seem prudent for potential buyers to wait out the rate increases. However, real estate can be a good shelter during inflationary periods, with fixed-rate mortgages stabilizing housing costs and houses appreciating in value faster than inflation. It can help you build wealth even when the market is falling. Whether you should buy now or wait a couple years is wholly dependent on your savings and cash flow.
There are several ways to mitigate the increase in monthly payments due to higher mortgage rates should you choose to buy.
Adjustable-rate mortgage (ARM)
An attractive option could be an adjustable-rate mortgage, or ARM. These mortgages are variable-rate home loans, typically beginning with a period of lower fixed interest, after which your interest rate adjusts based on the market level. Oftentimes ARM terms are expressed in two numbers, like 2/28, which means the first two years have fixed interest rates and the remaining 28 years are adjustable. Likewise, a 5/10 means five years fixed and 10 years adjustable.
These types of mortgages can be a good choice for buyers who think interest rates will continue to rise during the next few years and then fall. They are also helpful for buyers who expect to sell sooner rather than later, keeping the loan for a limited period of time. It’s important to note, though, that you should make sure you can afford any potential increases in your interest rate.
Fixed-rate mortgage + refinance
Another option for potential buyers is a combination of a fixed-rate mortgage and refinancing. Fixed-rate mortgages typically carry higher costs upfront compared to ARMs, but they do have the added benefit of stable monthly payments. With a fixed-rate mortgage, you’ll never be surprised by a jump in interest rates. After a couple of years, once you’ve paid down 20-25% of the principal, you can then apply for refinancing at a potentially lower rate.
This combination can be a good choice for buyers who have low risk tolerance and prefer stable payment amounts. ARMs can prove risky, betting that short-term interest rates will be higher and longer-term rates will be lower. But that isn’t always the case, and ARMs were a major culprit in the 2007 Financial Crisis, when interest rates jumped uenxpectedly and left many unable to afford their housing payments.
Of course, you can also refinance an ARM. In fact, switching from an ARM to a fixed-rate mortgage is one of the most common reasons for refinancing. The combination you choose is largely based on your preferences.
Home-buying incentive programs
A third option to counteract higher mortgage rates is to participate in home-buying incentive programs.
Rocket Mortgage announced a new program in September 2022 called the Inflation Buster that effectively drops a buyer’s mortgage rate by one percentage point for the first year, funded by the company as an incentive to finance through them. The lender also offers a Rate Drop Program, which covers a portion of closing costs if interest rates drop and owners refinance within three years of purchasing a home.
Some lenders may also offer mortgage rebates, also known as lender credit or negative points. These are typically cash-back programs that lenders use to entice buyers to close a deal, reducing closing costs like appraisal costs, title searches and other fees. Sometimes these are offered in tandem with higher mortgage rates, so be sure to ask what the trade-off is prior to committing.
On the other hand, you can also try a combination of positive points and lower mortgage rate. Just like how a rebate may be offered with a higher mortgage rate, you can snag a mortgage with a lower rate if you’re willing to pay more at closing time. This might not be feasible for cash-strapped buyers, but it’s still an option.
Certain programs aimed at first-time home buyers and disadvantaged or minority populations can help reduce your monthly costs, too. These programs range from down payment assistance programs, which reduce your initial down payment requirements in order to secure your loan, to special financing that waives private mortgage insurance or even subsidizes your mortgage rate. There is no centralized directory listing all available programs, so you’ll need to specifically look up programs for which you might qualify and ask your lender.
Bottom line
Higher mortgage rates can double your potential monthly housing payment compared to lower rates, making it harder to build wealth through homeownership. As a result, millions of potential homebuyers have been priced out of the market for the foreseeable future. However, if you have the savings and income, you can still buy a house when rates are high – and do it smartly. By considering different mortgage types and applying for specific home-buyer incentive programs, you can effectively lower your monthly payment now and in the future.
