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In November of 2012, mortgage rates dropped to a record low of 3.35%. Before that time, mortgage rates had NEVER been lower. For some perspective, the monthly payment for a $100,000 loan at the historical peak rate of 18.45% in 1981 was $1,544, compared to $441 at the much lower rate of 3.35% in 2012. For the rest of the decade, mortgage rates stayed in the 3.45% to 4.87% range. By December 2020, at the peak of COVID, the 30-year mortgage rate fell to a new historical low of 2.68%. Rates spent most of 2021 between 2.70% and 3.10%, allowing homebuyers to buy homes at the lowest rates ever recorded. And then mortgage interest rates seemed to more than double virtually overnight. What happened?
So, What Happened to Drive the Mortgage Rates Up So Fast?
By mid-2021, the economic leaders of the country were using the term – Transitory Inflation (what we now call putting your head in the sand). The American Institute of Economic Research defines transitory inflation as a rate of inflation that does not remain high permanently. The Federal Reserve’s job is to promote a healthy U.S. economy. They also set the Federal Funds Rate, which technically has no correlation with home mortgage rates other than a psychological one. However, when one rises, the other usually does.
The Federal Reserve (The Fed) promoted the Transitory Inflation narrative through 2021 and early 2022. The primary tool The Fed has is to increase interest rates to discourage spending from both consumers and businesses to promote reduced economic activity. By mid-2022, inflation had increased to the point The Fed couldn’t ignore it any longer. In fact, it had grown to the highest rate in 40 years. They then took the most historically aggressive position ever regarding interest rate increases. They implemented seven steep rate increases in nine months. The result was mortgage rates more than doubled from the beginning of 2022 until the end of 2022.
Can I Still Buy a Home with Today’s Interest Rates?
The answer is yes! If you could qualify for a home before the rate increase, you can still qualify for a home now. But the reality is that you may not qualify for as much of a home now. Let’s take a quick sidebar. A lender looks at your debt ratio as a key indicator to determine how much debt you can afford to have and still make your mortgage payment.
There are two ratios used to determine that for you. They are typically known as your front-end ratio and your back-end ratio. Let’s just talk about the front-end ratio here.
A front-end ratio is also known as the housing ratio. This ratio is calculated by dividing your projected monthly mortgage payments by your gross monthly income (your income before taxes). Your projected mortgage payment will include the costs of the principal, taxes, insurance, and interest payments, collectively known as PITI.
You earn $60,000, which is $5,000 per month
Your PITI comes to $1,450 per month
$1,450 / $5,000 = 0.29, or a front-end ratio of 29%
Your lender will set the terms, or the limits, for conventional loans. Depending on the lender, expect a limit of 28% for the front-end ratio. Federal Housing Administration (FHA) loans allow for a maximum front-end ratio of 31% as of 2018.
Going back to the original example, in 2012 the interest rate was 3.35%. The payment on a $200,000 mortgage would have been $882. Today at 6.6%, that same payment with interest is $1,278. That extra $396 in mortgage payment goes right into the debt ratio calculation. Remember, you still have to add Taxes and Insurance. So, you can still qualify for a home if this ratio and your other credit criteria are good. The only thing that has changed is how much home you can buy and still stay within the parameters of the front-end housing ratio.
A 2023 Home Buying Strategy: No Gimmicks
Some have taken a wait-and-see approach to interest rates. But while interest rates may go up or down, the one thing that isn’t going down is the cost of building a new home. Since 2020 the cost of building a home has gone up almost 27%. The longer you wait, the higher the price for your next home. So, should you wait? The answer is probably no. If you can buy a house now, buy a home. You can always refinance the home later if interest rates come down.
The goal is to get the most home for the lowest monthly mortgage. There are several methods to accomplish this. But beware, there are many lenders and builders out there with short-term gimmicks that could leave you in a bad position a few years from now. The first thing to do is determine if you are buying a home for the long term or if this is home is going to be lived in under three years.
One of the current “gimmicks” is the temporary buydown. These provide home buyers with a lower monthly payment for the first year and the second year, but what happens when that full payment kicks in on the third year? On a $300,000 loan amount, with 7% being the end result, a 2/1 temporary buydown means a monthly payment increase of almost $400 from what they were paying that first year.
Another option that was tried in the early 2000s was the interest-only loan with a balloon payment. If you are a short-term homeowner, then this may sound like a great option. But there is no guarantee the market will be right for reselling when the balloon payment comes due. As a homeowner, what if you can’t qualify for the payment on the new home based on the appraisal and the interest rate three years from now?
It’s not a gimmick, one of the better options today to get that lower payment is to go back to the basics of buying the rate down with points. Mortgage points are the fees a borrower pays a mortgage lender in order to trim the interest rate on the loan, thereby lowering the overall amount of interest they pay over the mortgage term. Sometimes this is called “buying down the rate.” It’s not a temporary solution. If you are in the home for the long term, this may be the safer, better option. You can still refinance if the rates come down in the future, but you are still comfortable in the payment you have chosen if you don’t or can’t.
Some Final Tips for Mortgage Success in 2023
You have options to help you qualify for the home you want. Here are some additional tips:
There are some lenders that will allow you to have a back-end ratio that’s as high as 50%. Of course, you have to have great credit. Look around and search for these lenders.
If you have loans with small balances (for example, small credit card balances), wiping these out completely will help reduce your back-end ratio.
Save more down payment. By increasing your money down, you lower your PITI, which improves your ratios.
Another option is to find a less expensive house which would lower your PITI.
Once you have done everything to reduce your debt payments, you will see a corresponding reduction in your debt ratios. The next option to reduce your ratios is to increase your income. Ask your boss for a raise! Today’s higher interest rates aren’t killing the American Dream – they are just making home buyers have to work harder and work smarter to get it.
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