How Do Interest Rates Affect Mortgages?

Mortgage interest rates can have a major impact on a borrower's monthly payment and overall costs. For those trying to sell a home, understanding how interest rates affect mortgages is essential. 

Here’s a look at the various ways that mortgage interest rates can affect a borrower's financial situation and what you should know about the rising interest rates.

What is a Mortgage?

Mortgages, in short,  are loans provided by a mortgage lender to a borrower to purchase a home. From there, the borrower is responsible for paying back the loan, plus interest, over a specific amount of time. The borrower will typically send payments to the lender each month to pay back their loan. 

Monthly payment amounts are generally decided by the terms of the loan itself. This includes:

• The current amount borrowed
• The interest rate
• The length of the loan, which can be anywhere between 15 and 30 years

What is the Interest Rate?

When you take out a mortgage loan, you’ll have to pay a certain amount of fees which is charged by a lender for the use of its money––otherwise known as the interest rate. 

The interest rate is usually expressed as a percentage of the mortgage loan amount. This amount can vary and may be higher or lower, based on the borrower’s credit score. Interest is calculated as a percentage of the set loan amount, and is paid off (often on a monthly basis) during the life of the mortgage or home loan. When you do decide to take out a loan, you’ll have to agree on the interest amount before you’re able to borrow money from a lender. 

How Interest Rates Affect Mortgage Payments 

Mortgages and interest rates are closely related, as they both have a major impact on how much a borrower pays each month and in total for their loan. Interest rates are fees charged by lenders for taking out a loan. They are calculated using a number of factors, including the borrower’s credit score and the type of loan. 

Types of Mortgages

There are two types of mortgages you should know: fixed rate and variable rate. 

• Fixed-rate mortgage: These types of mortgages have set interest rates. The rate won’t change throughout the life of the loan.
• Variable-rate mortgage: A variable-rate mortgage has an interest rate that may fluctuate depending on current market conditions or real estate market trends. 

With both types of mortgages, higher interest rates mean more expensive monthly payments for borrowers. 

To show how interest rates affect what a borrower pays, let's pretend a home costs $250,000 and has a 30-year fixed-rate mortgage. Below is the difference in monthly payments and total interest paid at 3% versus 7% interest rate:

At 3% interest rate:

• Monthly payment: $1,054.54
• Total interest paid over 30 years: $105,395.48

At 7% interest rate:

• Monthly payment: $1,663.26
• Total interest paid over 30 years: $409,220.68

As you can see, the difference of 4% in interest rate can result in a significant increase in monthly payments as well as total interest paid over the life of the mortgage. 

So, how will interest rates affect the housing market? Interest rates have been hovering around 7%, leading home sales to decline for 12 consecutive months, according to The National Association of Realtors. So, homebuyers should carefully consider the interest rate when choosing a mortgage loan, because can greatly impact their home-buying options as well as the total cost of homeownership. 

Inflation and Interest Rates

Inflation also plays a role when it comes to understanding how interest rates impact mortgages. As prices of goods and services rise, so do the costs of borrowing money. When the cost of living goes up, the Federal Reserve will usually increase the interest rates to combat this. The goal is for higher interest rates to encourage people to save their money. This means that any consumer loan – including a mortgage loan – will also be subject to higher interest rates. 

When the Federal Reserve raises interest rates, it’s known as an “interest rate hike” or a “central bank rate increase.” As interest rates climb, the monthly payments on loans become pricier, and the total cost of borrowing money increases. For potential homebuyers, this could mean the difference between an affordable monthly payment and one that makes them rethink the transaction altogether. Paying close attention to current reports from the central bank is crucial, since changes to interest rates can drastically impact a borrower’s ability to obtain a mortgage loan.

How Higher Interest Rates Affect Buyers and Sellers

Rising interest rates can affect both buyers and sellers in the market. For buyers, higher interest rates mean a higher monthly mortgage payment and less money available to be able to buy a home. When interest rates are higher, borrowers must take out larger loans to afford the same home. 

This means that buyers allocate more money (often beyond budget) in order to pay the higher monthly payment for the loan. Additionally, since lenders usually consider the interest when setting loan limits, borrowers may find that they only qualify for a smaller loan which means that they aren’t able to afford more expensive homes.

For sellers, higher interest rates can also have a significant effect. When the rates go up, buyers may rethink buying or may not be as willing to pay as much for a home. In turn, home prices could go down as buyers are not able to get as much loan money and are less likely to take out larger loans. This may force sellers to accept lower offers if buyers cannot afford the full price of the home due to the higher rate.

Navigating Interest Rates

To navigate the uncertain market, homebuyers should look for loans with lower interest rate options and make sure that they are budgeting correctly for the extra monthly mortgage payment that comes with a higher rate. 

Likewise, sellers should be prepared to negotiate on the home price and adjust their expectations in light of current market conditions. This could mean providing additional incentives to encourage potential buyers, like flexible timelines and a few home improvements.

Consider a Sell and Stay Transaction as an Alternative to Moving

So, if you’re trying to sell your home but are intimidated by the current housing market and rising interest rates, a sell and stay transaction may be an attractive option for you. This process involves selling your home and then leasing it back as a renter. 

Through a sell and stay transaction, you are able to unlock your equity while remaining in the home you love as a renter. If you’re interested in exploring this option, get in touch with one of our representatives. 

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Sources: 

1. Bankrate. Latest mortgage news: After Fed’s warning, rates flirt with 7% again. https://www.bankrate.com/mortgages/analysis
2. Credit.Org. What Are Interest Rates & How Does Interest Work? www.credit.org/blog/what-does-interest-rate-really-mean/ 
3. Forbes. The Impact of Interest Rate Increases on the Mortgage Market. www.forbes.com/sites/forbesfinancecouncil/2022/12/07/the-impact-of-interest-rate-increases-on-the-mortgage-market/ 
4. CFPB. How Do Mortgage Lenders Calculate Monthly Payments? www.consumerfinance.gov/ask-cfpb/how-do-mortgage-lenders-calculate-monthly-payments-en-1965/ 
5. FHFA. FHFA Announces Conforming Loan Limits for 2022 | Federal Housing Finance Agency. www.fhfa.gov/Media/PublicAffairs/Pages/FHFA-Announces-Conforming-Loan-Limits-for-2022.aspx.