Interest Rates vs. Purchase Price

Everyone except those in denial knows that home prices are going to take a tumble crash until it’s back to fundamental normals. Great news for buyers on the sidelines right? Well, what about the offset effects of rising interest rates? Rates have been at historic lows the past few years and it looks like Bernanke and his cronies are going to continue dropping rates in hopes of preventing a full blown recession.

Realtors will try to spin this off and sell it to uninformed buyers that low interest rates is a great reason to buy right now. I hear this argument often and it’s simply not true. Even if the Feds continue to lower rates all the way down to 1% to keep the economy afloat, it doesn’t mean it’s a good time to buy just because you can land a low interest loan. Yes, interest rates won’t stay low forever and will eventually go up quite a bit. So what does that mean for potential buyers?

Let’s take a closer look at what’s more important when it comes to your monthly mortgage payment – interest rates or purchase price? Since there are no more liar loans nor secondary mortgage market, I have assumed the traditional 20% downpayment requirement and 30-yr fixed rates. No more nilly willy lending free money. Also, for the sake of simplicity I did not differentiate between jumbo and non-jumbo loans in this example – just assume a higher rate if your loan amount will be above $417k. For the income requirement column, I’ve assumed a purchase price-to-income ratio of 4X.

All monthly payment estimates were taken from this simple mortgage calculator. As shown below, it’s clear that purchase price is more important when it comes to saving you money.

Example 1: A $320k loan at 10.5% (10.5%!!!) still has a lower monthly payment than a $480k loan at 6.5%.

Example 2: A $480k loan at 8.5% still has a lower monthly payment than a $640k loan at 5.75%.

interest_rate_vs_house_price.JPG

So when everyone says it’s the “worst time to buy” because home prices have been falling for several years straight and interest rates are high (perhaps much, much higher by 2012), it’s actually a GREAT time to buy. Interest rates and home prices are on opposite sides of the seesaw because interest rates dictate how much money buyers can borrow and by extension, what home prices will be.

I’ll be okay buying a home at say 10% fixed for 30 yrs because that will mean house prices have fallen considerably from their peak prices. You can always refinance to a lower rate because rates will change over the course of 30 yrs, but you cannot change the purchase price of your house after you sign papers.

Therefore, it’s better to buy when interest rates are high and prices are low than when interest rates are low and prices are high.

6 thoughts on “Interest Rates vs. Purchase Price”

  1. Great analysis, SavedbyGrace! I will keep a copy of this post to remind myself and others. Thank you.

  2. While the interest rate cuts may be good for homeowners who can qualify for a refinance (i.e. full doc income and not underwater), it’s a confusing time for many potential buyers. I wrote this post because I ran across several such buyers just this week who were considering starting a home search “because interest rates are so low.”

    It took me one minute to show them a mortgage calculator online and an additional 5 minutes for them to figure out it’s still better to wait out the crash a bit longer.

    Knowledge is good.
    Knowledge + Patience is even better.

  3. This is an excellent post – thank you! May I add one thing?

    The real estate market is different from the stock market in that (among other things) the “ask” price of one item for sale (i.e. stock vs. property) does not dictate the “market value” for all other same or similar items (for sale or not…).

    It is possible in real estate to buy a property BELOW market value. And there are more than one ways to do this. However, looking at MLS asking prices only, and thinking you’d have to *wait* until they drop to where you would consider buying, is certainly the “long way home”.

  4. At 5% interest cost I can borrow $325,000 to pay for a house for $1,750. At 10% interest my loan drops to $200,000 for the same $1,750. Unless there is extreme reduction in supply or demand is as high as those in the housing bubbles day I am afraid home price will rust in a low inflation and eventual hike in interest rate environment. Please share any other important forces and give us a measurable change if you think of any.

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