As interest rates drop below 3%, many buyers (and refinancing home owners) are jumping into action. While lower interest rates can equate to lower monthly payments or higher purchase power, there are some possible repercussions for the housing market. Here’s a closer look at both sides of the coin.
Upside #1: Higher Purchase Power
Certainly the upside to lower mortgage rates is the ability to afford more house—whether that comes with more square footage, a more upscale neighborhood, or both. As a rule of thumb, each quarter point swing in interest rates changes the amount a buyer can borrow by about 3%. That means just a 1% decrease in interest rate has the potential to increase a buyer’s borrowing power by 12%! Say the interest rate falls just 1% in the example below where the monthly payment stays the same:
5.35% for $183,608 loan
4.35% for $205,959 loan
With a full-point drop in interest rates, the borrower can afford over $22,000 more in a home!
Upside #2: Lower Monthly Payments
Of course, a lower interest rate can also mean lower monthly payments. Say a home owner has been paying off a $300,000 loan at 4% interest and refinances at $2.99%, They could see a $1,432 monthly payment drop to roughly $1,263. That’s an annual savings of $2,028.
Downside #1: Less Incentive to Sell
While the upsides to lower interest rates immediately effect the consumer positively, there’s a possible longer-term effect. At some point, interest rates will start to climb again. For many of the home owners who were able to enter ownership because of the low rates, the ability to buy a move-up home could be stifled by new, higher rates. That translates into owners staying longer in a home than expected, which means less inventory overall for buyers. Less inventory means home prices are driven up due to scarcity, making it more difficult for new buyers to enter the market.
Downside#2: Investors May Flood Key Housing Markets
In the last housing recession, institutional investors took advantage of the depressed property availability and bought up homes in bulk to turn them into rentals. With rates dropping to historic lows, these investors may find it encouraging to finance their purchases and increase their property portfolio. Because real estate investors typically hold on to profitable rental property for the long-term, this could mean even lower inventory for residential buyers in key rental markets. Again, low inventory drives up prices and affects home affordability.
Could New Construction Help Inventory?
Since low inventory is the common thread in the downsides mentioned, we could look to new construction as a way to bring more homes on the market. But builders have struggled for years to meet demand due to high cost of lumber and a shortage of skilled workers. These factors have forced them to focus on more upscale homes where profit margins are higher. Still, there is no question that today’s low mortgage rates are benefiting buyers and instilling confidence in housing. That’s a great incentive for builders to tap into as many market tiers as possible.
Real Estate Term of the Week
Absorption Rate: The rate at which homes sell in a specific market over a given period of time, usually a month. The absorption rate is calculated by dividing the number of homes that sold over the given period of time by the total number of homes still for sale. If an area contains homes in two different price ranges, you can calculate the absorption rate just for homes in your price range. The higher the absorption rate, the faster homes are selling.