How Rising Interest Rates Can Impact Your Homebuying Power

Recent changes in the broader economy have caused the Federal Reserve to raise interest rates to their highest level since the 2008 financial crisis—significantly impacting the purchasing power for first-time homebuyers and seasoned homeowners alike.

Despite this, mortgage interest rates remain below the higher averages seen from the 1970s through 2008.

But while interest rates remain near historic lows, the sharp increase in rates in late 2022 has left some homebuyers worried that they may be priced out of their dream home.

If you’re planning on purchasing a home, you should know that while interest rates are rising, it doesn’t mean purchasing a home is unattainable. It just means you need to stay informed and partner with the right financial institution that can help you make your homebuying dreams a reality.

How Do Rising Interest Rates Impact Homebuying Power?

In general terms, as interest rates go up, the amount of home you can afford goes down. This hit to homebuying power happens for several reasons:

• Higher interest rates generally translate into higher mortgage loan costs—meaning the amount you’ll have to pay in interest (and your monthly payment) will be higher.
• Rising interest rates tend to cool down the homebuying market, meaning fewer sellers will list their homes. Fewer buyers and sellers in the market means less inventory for you to choose from.
• Higher interest rates in combination with lower credit characteristics may make it more difficult for some people to qualify for a mortgage.

While there are several factors in play, the key thing to keep in mind is that higher interest rates typically do lower the amount of house you can afford.

Higher interest rates impact a bank’s ability to lend you the same amount of money they would if rates were lower. Further, higher interest rates mean that your monthly payment will go up to account for the increase in interest you’ll pay over the life of the loan.

Generally, these increases follow the 1/10 rule, which is a good way to estimate how much rising interest rates could impact your homebuying power.

Using the 1/10 Rule to Determine How Much House You Can Afford

The 1/10 rule states that when interest rates go up by 1%, your buying power goes down by 10%. The reverse also holds true, as a 1% decrease in interest rates means you can purchase roughly 10% more house.

For example, say that you qualified for a $500,000 mortgage at an interest rate of 3%. Then, the interest rate rose to 4% overnight. How would this 1% increase affect your buying power?

Using the 1/10 rule, a 1% increase in the interest rate would translate to a 10% decrease in your buying power. This means that—all other things being equal—you’d only have $450,000 of purchasing power to buy a home at the new 4% interest rate.

To draw this example out into the real world, if you qualified for a $500,000 mortgage in 2021 when interest rates were 3%, then you would see a 30% reduction in your buying power if you chose to purchase a home at an interest rate of 6% in 2022. This would translate to a loss in buying power of around $150,000.

Put another way, if you could have afforded a $500,000 house at a 3% interest rate in 2021, the higher interest rates in 2022 mean that you would only be able to afford a house worth $350,000 at an interest rate of 6%.

What Happens to Mortgages When Rates Go Up?

Mortgages become more expensive when interest rates go up. This is because the interest rate on the mortgage goes up in relation to the interest rates set by the Federal Reserve.

The Federal Reserve is tasked with monitoring and adjusting the nation’s monetary policy. The Federal Reserve has several tools it can use to affect the broader economy. One of the strongest and most useful of these tools is its ability to adjust the interest rates on loans between the government and banks (and even the banks themselves).

When people talk about the Federal Reserve “raising interest rates,” they’re generally referring to when it increases the rates on loans between these financial institutions (the Federal Reserve to banks, banks to banks, etc.).

As the cost of transferring money between these institutions goes up, banks need to raise the interest rates on the mortgages they offer to their customers.

In real-world terms, this means that the interest rates for mortgages will often closely follow the interest rates the Federal Reserve sets for transactions between the government and banks, and even between the banks themselves.

Fixed-Rate vs. Adjustable-Rate Mortgages

The two most common types of mortgages are known as fixed-rate mortgages and adjustable-rate mortgages:

• Fixed-Rate Mortgage — A fixed-rate mortgage charges a rate that stays the same throughout the life of the loan. This interest rate is determined by several market factors and loan parameters.
• Adjustable-Rate Mortgage — An adjustable-rate mortgage charges a rate that adjusts based on the market after the initial fixed period. Often, the rates on these mortgages are lower than fixed-rate mortgages. When the Federal Reserve adjusts the interest rate on loans between banks, it can have a large impact on adjustable-rate mortgages

When you’re shopping for a mortgage to buy a new home, it’s wise to compare the interest rates and annual percentage rate (APR) of various mortgage types to determine both the total cost of the mortgage and how much you’ll pay each month.

Rising interest rates will have different effects on each type of mortgage, so it’s important to compare the pros and cons of each as you build out a plan for buying a home.

Figuring out whether a fixed-rate or adjustable-rate mortgage is better for you can be complicated, especially when you throw rising interest rates into the mix. It’s wise to speak with your local banker to figure out your options and how best to move forward.

Planning for the Future and Your Family’s Needs

As 2022 draws to a close, mortgage rates are expected to continue to increase as the Federal Reserve attempts to reduce inflation. As interest rates go up, typically, the amount of home you can afford goes down. This trend generally follows the 1/10 rule, which states that a 1% increase in interest rates leads to a 10% decrease in your buying power.

In addition to lowering your overall buying power, rising interest rates can also raise your monthly payment as well as the total amount you’ll pay over the life of the loan.

However, while interest rates are at their highest levels since before the 2008 financial crisis, we’re still in a period where these rates are at historic lows compared to other points in recent history—like the 18% rates of the 1980s. So while you may not be able to afford the same amount of house as you could last year, from an interest rate perspective it’s still an excellent time to buy a home—especially when you partner with the right financial institution to help you in your homebuying journey.

Want help with finding the best mortgage that works for your unique situation? Schedule an appointment to meet with a dedicated expert at an Associated Bank near you. We’re here to help you achieve all your financial goals, meet rising interest rates head-on and make your homebuying dream a reality.