I put the word fun in quotations because while the following exercise is supposed to be entertaining, it might scare a few people.
It’s important to consider just how crucial interest rates are to the affordability of residential housing, and how much of a factor rates play in the valuation and fluctuations of real estate.
Over the Thanksgiving weekend, I found myself taking what was supposed to be a long “tranquil” walk along a family friend’s 50-acre farm, but before long, the conversation had shifted to the housing market and what’s going on with interest rates.
My senses started to ignore the beautiful fall foliage and the playful laughter of the kids running through the field ahead and I got that queasy feeling in my stomach as I heard the words “twenty-two percent.”
Uncle Herm was telling us what it was like to try and make mortgage payments back in 1981 when the prime rate was 22.75%.
He went on to tell us that his mother jumped at the chance to lock into a fixed-rate mortgage once rates had “dropped” to 15% in 1982. It was a shame that over the next five years, rates steadily decreased until they were as low as 8.75% at one point during 1987.
When I locked into my 5-year, 4.99% fixed-rate mortgage in June of 2007, I had contemplated taking a 7-year, 5.49% mortgage instead. I figured that there was more downside than upside (in this case, the downside is rates going up, and the upside is rates going down). Last year, rates rose to the point where a 5-year-fixed was higher than the rate I could have received for my 7-year-fixed.
But you know what?
Hindsight is 20/20 with interest rates just like the stock market, and if we all had a crystal ball, none of us would be working right now.
But all this talk got me wondering what the numbers would look like at interest rates that many of us have never seen.
For example, a $300,000 mortgage at 4.99% amortized over 25 years would produce:
Monthly Payment: $1743.11
Principal Portion: $508.38
Interest Portion: $1234.73
So what if rates rose an entire percentage point to 5.99%?
Monthly: $1917.64
Principal: $438.49
Interest: $1479.15
An increase of one percentage point would raise the monthly payment by $174.53, or 10.0%.
Since I locked into my 4.99% rate in June of 2007, I’ve seen rates fluctuate up and down. Several of my clients have locked into rates above 5.50% when rates increased late last year, and before they went back down again!
Does it get tiring watching the fluctuations of interest rates? Well, ask a mortgage broker, I guess. But fluctuations happen with rates just like they do with publicly traded equities on the stock market.
Had I waited a few months to purchase my condo last year, my monthly payments would be significantly higher due to the higher rate I would have received. Even a half-point would have increased my monthly liability by just under $100.
It really makes you think about what would happen if rates were up at 22% again!
So what if rates rose to something like…..8.5%? We’ve seen rates like this before, and in 1992 it seemed like a dream!
Monthly: $2386.09
Principal: $297.78
Interest: $2088.32
Notice how the principal portion of the mortgage significantly decreases as the interest rate goes up? Here we have a much higher payment at $2386.09, but less than $300 of that is principal!
How does this affect affordability in the housing market?
Take the example above where a buyer or a young couple had a $300,000 mortgage and were making monthly payments of $1743.11 due to their 4.99% interest rate. Now if rates rose to 8.50%, they would have to come up with $2386.09 per month! Imagine barely being able to make payments, and then having to come up with $643/month more!
And as I’ve mentioned above, we haven’t considered the ramifications of the lower principal portions. Part of the “hidden asset” of your mortgage is the fact that you get back a portion of your monthly payment in the form of equity—the principal!
In the 4.99% example, your monthly mortgage payments after one full year would result in $6240.59 of principal.
But in the 8.5% example, your principal portion shrinks to $3713.29!
Think about that: you’re making a higher monthly payment each month, but the portion of the payment that you actually get to keep (principal) is LESS!
Well, I think it has something to do with that darn interest rate.
Just for fun, let’s see what it would be like if rates were at 22.5% in our $300,000 mortgage example:
Monthly: $5409.29
Principal: $26.17
Interest: $5378.13
Yeah, seriously.
Imagine paying $5400+ per month and essentially ALL of it is interest!
How did people live back in 1981 with this going on?
That’s a rhetorical question, since I can’t possibly begin to understand the answer.
It’s good to keep an eye on interest rates, but don’t consume yourself with it, and don’t get greedy playing around with variable rates trying to save a few basis points when the sky is essentially the limit with respect to how high rates can go.
I don’t think we’ll be seeing anything quite like what happened in the early 1980’s any time soon, and my personal opinion is that this may never happen again in our lifetimes. But that is a topic for much, much debate…
