How Interest Rates Affect Monthly Payments—the Math

(Michael Wick/Shutterstock)

Commentary 

The party’s over for many would-be homeowners. The “party” I’m referring to is the historically low interest rates that made borrowing money the most affordable it had ever been. As of August 2022, the average interest rate on a 30-year fixed Freddie Mac mortgage is 4.99 percent, which is up from about 2.68 percent in December 2021.

Before we discuss the math of this and how it affects consumers, let’s take a look at how these numbers are derived. A borrower’s mortgage rate is determined by external economic factors as well as the borrower’s credit history and other factors, such as their debt-to-income ratio. The main external driver of mortgage rates is the Federal Reserve. One of the Fed’s main purposes is to maintain a stable inflation rate. The way that the Fed is able to regulate the inflation rate is through the federal funds rate, which is the rate at which banks borrow money from each other overnight.

By loosening or restricting the amount of money that banks borrow from each other, the Fed is able to control the nation’s money supply. If short-term interest rates are low, that makes it more affordable to borrow, which increases the overall money supply in the economy and pushes up prices. On the other hand, if interest rates are higher, that means that less money is available, and prices go down, which will eventually curb inflation.

For most of 2020 and 2021, the Federal Reserve was responding to the high unemployment and overall fallout of the pandemic. In an effort to prevent the economy from stalling out completely, the Fed had been keeping short-term interest rates at or near zero percent, most recently in response to COVID-19. The effect this had on the real estate market cannot be overstated. But now that has changed.

The Math of Mortgage Points

So we know that mortgages are rising, but what does that translate to in dollars and cents? The short answer is that an increase of one percentage point on a mortgage can cost the borrower tens of thousands of dollars more. One mortgage point equals 1 percent of your total loan amount. Calculating the exact difference is a complex equation for which you’ll need a mortgage calculator. (See the figure below.)

We can look at the effect one point would have on a mortgage by looking at a hypothetical property worth $200,000. Let’s say that you’ve been able to make a downpayment of $40,000, with a $160,000 mortgage. A one percentage-point increase on your mortgage would increase your monthly payment by almost $100. Although the difference in monthly payments may not seem that extreme, that one-point increase means you’ll pay approximately $30,000 more in interest over the 30-year term. Obviously, with the average house in the United States going for about $428,000, a one-point change on a mortgage of that size would be far higher.

The effects of these higher rates have had an immediate impact on the housing market, where sales have slowed after the frenzied buying of 2021 and early 2022. According to Relator.com, active listings on its site jumped 128,200 in June of this year, to 747,500 in July. That’s the largest increase in the site’s database since 2016. Another reason for the cooling of the housing market is that inflation overall still remains high, which has reduced the buying power of the average American.

In June, the Fed increased its benchmark interest rates by 75 basis points, and did so again in July, for a total of 150 basis points, or 1.5 percent. (A basis point is equal to one hundredth of 1 percent.) This is the steepest rise since the early 1980s. It remains to be seen what the Fed’s long-term strategy on mortgage rates will be. Currently, markets expect the Fed to raise rates at least another half of a percentage point in September and then start lowering rates in the summer of 2023, although that’s still just a prediction. In fact, the Fed’s own committee projections don’t expect there to be any cuts until 2024 at the earliest.

Whether the lowering of interest rates starts next year or even later, the health of the U.S. housing market, for the immediate future, will depend on the continued strength of the job market and consumer confidence. The Consumer Confidence Index has been in a slight decline recently, slipping to 95.7, its lowest level since February 2021. This figure is still well above the index during the Great Recession of 2007–09, when that number bottomed out at 25.3. However, if inflation remains high, that could drag down consumer confidence, which in turn could affect spending and, consequently, would lower housing prices. That’s good news for buyers, but not for the economy at large. Assuming consumer confidence and employment remain high, we could see prices start to grow again later this year.

(Ken McElroy)