But what do interest rates really mean for homebuyers? And how, specifically, do rising interest rates affect your ability to buy a home? That’s the question we are going to answer in this article.
Mortgage Basics: Debt-to-Income Ratio
First, let’s step away from interest rates and look at one of the basics of getting a mortgage: your debt-to-income, or DTI, ratio.
Mortgage lenders use lots of criteria to determine who they should lend money to and how much. Lenders look at credit history, state of employment, down payment funding and more when determining how much to lend to a potential homebuyer.
While bankers will ask how much you make monthly, they’re not looking at just that income number. Instead, they want to see how much of your income is available to pay a mortgage. To do this, they look at two DTI ratios:
Front-End Ratio: The first ratio is how much your mortgage payment will be divided by your monthly gross income. We’ll look at calculating this ratio in a minute. But for now, just keep in mind that this ratio typically should be no more than 28%.
Back-End Ratio: The second ratio looks at all your monthly debt payments, not just your mortgage. Your monthly payments on all debt should not exceed typically 36% of your gross monthly income.
In some instances, the ratios can be slightly higher, but 28/36 is the industry standard.
Calculating Your DTI
Luckily, you don’t need some fancy schmancy economist to calculate your DTI for you. You can do it yourself. For the back-end ratio (36%):
- Total all your current monthly debt payments (excluding your current mortgage payment, if you have one)
- Write down your monthly gross income (your income before taxes – you can find it on your pay stubs if you aren’t sure)
- Divide your monthly debt payments by your monthly gross income
- Multiply that number by 100 to get your DTI percentage
So if you have, for example, a $400 car payment, $50 credit card payment, and $300 student loan payment each month, your total monthly debt is $750. Divide that by your monthly gross income of, say, $5,000, and you have a DTI of 15 percent.
Now that you know your DTI, you can figure out what’s left in your budget for a house payment (which is why we exclude your mortgage payment in the above calculation).
(We’re getting to the whole interest-rates-affecting-home-affordability thing. Hang in there.)
We’ll use the bank average of 36 percent DTI as an example. If you’re devoting 15 percent of your total monthly income to debt, that means you have 21 percent of your monthly gross income left to devote to a house payment, property taxes and insurance.
And 21 percent of that $5,000 gross monthly income is $1,050 (because 5,000 x 0.21 = 1,050).
As noted above, lenders have a preferred back-end DTI and a preferred front-end DTI. Your back-end DTI can’t exceed, usually, 36 percent of your income, but your housing DTI (including insurance and property taxes) can’t exceed around 28 percent*. So even if you have very low debt, you probably can’t get a mortgage that will have you paying out 35 percent of your income every month.
* Remember, these are just estimates, based on mortgage lender averages. But you can expect DTI limits from most lenders to be around these percentages.
Interest and Affordability
OK, so following the above example, you have about $1,050 per month – maximum – to pay for your mortgage. Now let’s look at some examples of how interest rates have a direct effect on how much home you can afford.
Let’s make the following assumptions about mortgage situation:
- You can afford $1,050 per month (including property taxes and insurance)
- You have a down payment of $10,000
- Your property insurance and taxes will be about $2,500 per year
- Minus your $2,500/year in insurance and taxes, you can afford to pay about $841 per month on your mortgage’s principle and interest
Now, let’s see how interest rates affect how much home you can afford:
Scenario #1: 3.5 percent interest
Paying 3.5 percent interest, you could afford a mortgage of about $187,434. With your down payment, that brings your upper limit home price to $197,434.
The calculation is easy to do with this free online payment calculator we found on the United States Senate Federal Credit Union website of all places.
Scenario #2: 5.5 percent interest
Paying 5.5 percent interest, which seems like such a small increase, you could afford a mortgage of $148,235, for a home worth $158,235.
Scenario #3: 7.5 percent interest
Add two more percentage points in interest, and your mortgage limit drops to $120,373, or a home worth around $130,373.
So between 3.5 percent interest and 7.5 percent interest, which is really a huge leap in the world of mortgages, where things are calculated to 1/100 of a percent, you’ve lost over $67,000 of buying power.
Check out the table below for more scenarios of how interest affects affordability:
Interest Rates and Affordability*
|$800 Payment||$1,200 Payment||$1,800 Payment|
|Highest vs. Lowest Interest Difference:||$84,075||$138,110||$211,436|
As you can see, interest differences are amplified – the bigger your loan, the more difference 0.25 percent in interest makes overall. So if you’re after a mondo home loan, you should pay even more attention to interest rates.
Adding it All Up
Rising interest rates will have a serious effect on buyers. Those who were lucky enough to buy a home with a 3 percent interest rate were able to afford much more than they would have been able to pre-crash, when interest rates were a more typical 7 percent or more.
This does not mean that you should rush out and buy a home before interest rates go up further. Yes, 0.25 percent does make a difference in how much home you can afford. But rising interest rates are just one factor to consider.
Instead, if you’re considering buying a home, you might keep an eye on interest rates and be mindful that they’re trending upward. You might also want to improve your credit score, which is a great way to get a lower interest rate, and work on your DTI so that you can afford a larger mortgage when the time comes. You can check out today’s rates here.