Curve

How to deal with the 5 percent mortgage

Peter Miller
Peter MillerThe Mortgage Reports Contributor

In this article:

  • Mortgage rates are rising overall. That’s a fact we can’t ignore
  • However, many are overestimating the effect on home affordability due to small increases in interest rates
  • There are options for those who want to buy but are concerned about financing costs

Information is power. The more you know, the less worried you’ll be when buying a home.

Verify your new rate (Oct 15th, 2018)

5 percent mortgage are baaack. But they aren’t zombies

The 5 percent mortgage is back. It’s not as though some magical barrier existed at 4.875 percent, our average mortgage rates on October 3rd. Then they hit 5 percent on October 4th. 

The real estate world will not end, but borrowers may want to re-think their mortgage options. As we shall see, there are strategies to reduce mortgages rates and interest costs.

Wanting more for less

The goal of every borrower is to pay less for mortgage financing. With that standard, no time for borrowers was better than the past decade. The last time the average annual interest rate topped 5 percent was in 2009, according to Freddie Mac. By 2016, the average annual rate reached 3.65 percent, the lowest since records were first kept in 1971.

Related: Rising mortgage rates affect home affordability, but less than you think

How good have rates been in the past decade? Freddie Mac reports that the average mortgage rate between 1971 and August 2018 was 8.16 percent. That fearsome 5 percent rate is more than 3 percent lower than the long-term average.

But let’s be honest. Nobody cares that today’s rates are low by historical standards. What everyone does care about is that rates are up when compared with recent years.

The 5 percent mortgage and change

What’s important is not so much that rates are up but that the marketplace is changing. Both real estate and money are commodities. Their prices go up and down.

Related: How much house can you afford? You’ll know in 5 minutes

The National Association of Realtors (NAR) reports that as of August, the typical existing home sold for $264,800.  That’s an increase of 4.6 percent from a year earlier and the 78th straight month of year-over-year gains. With rising interest rates, can we expect home price increases to slow? Is it possible that home prices might generally fall?

The 5 percent mortgage and sales

There are already signs that the market has begun to cool. NAR says, “Existing-home sales remained steady in August after four straight months of decline.” Sales are actually down 1.5 percent from last August.

Fewer closings are likely to continue. Lawrence Yun, NAR’s chief economist, estimates that each .1 percent mortgage rate increase results in 35,000 fewer sales.

Related: Home price growth and inventory shortages back off

Fewer sales suggest more supply and less demand. That combination should lead to lower prices or smaller price increases. However, in today’s market, many areas may see both fewer sales and rising prices. How is that possible?

The inventory shortage

One reason for steadily-rising home values has been an acute inventory shortage.

Related: October 2018 mortgage interest rates forecast

“While inventory continues to show modest year over year gains, it is still far from a healthy level and new home construction is not keeping up to satisfy demand,” said NAR’s Yun.

“Homes continue to fly off the shelves with a majority of properties selling within a month, indicating that more inventory — especially moderately priced, entry-level homes — would propel sales.”

Supply and demand

Fewer sales should mean less demand and lower prices. Lower prices might then offset higher mortgage rates.

Related: Tired of the rent race? More affordable cities

For example, a $1,500 monthly payment for principal and interest at 4.75 percent can support a $287,550 mortgage. With a 5 percent mortgage, the same $1,500 monthly payment is only enough to borrow $279,422.

In a market with higher financing costs and fewer sales, there will likely be lower prices in many metro areas. But this time around – with less inventory – maybe not.

The problem of affordability

A related issue concerns affordability. When rates were lower, affordability was still a concern for many borrowers. ATTOM Data Solutions explains that “U.S. home prices in the third quarter were at the least affordable level since Q3 2008 — a 10-year low.”

If affordability was bad before the return of the 5 percent mortgage, then it will be worse going forward. This will mean fewer buyers and less demand, a combination which should result in lower prices. But, again, we have the inventory shortage pushing up prices.

ARMing for rate increases

What can buyers do to offset today’s rising rates? There are two alternatives.

If the concern is that higher mortgage rates will make financing unaffordable, consider the use of a 5/1 ARM. At this writing, such financing is likely to have a five-year start rate about .75 percent lower than fixed-rate financing.

Related: How ARM rates work (3/1, 5/1, 7/1 and 10/1 loans)

Example: Instead of 5 percent fixed-rate financing, you might be able to find a 5/1 ARM in the 4.2 percent range, and a 7/1 ARM in the 4.3 percent area.

The risk: ARM rates and monthly payments may go higher once the start rate ends. As long as you expect to refinance (and rates are cyclical; what goes up does tend to come down) before that period ends, you can minimize that risk. Ditto if you expect to sell before the fixed introductory rate expires.

The 15-year solution

If the goal is to lower interest costs, and you have the ability to comfortably make bigger monthly payments, consider 15-year fixed-rate mortgages. Even if the rates were the same as 30-year mortgage rates, you’d save substantially. Because you cut your borrowing time in half. But you’re also likely to be rewarded with an interest rate about .5 percent lower.

However, because the term of the loan is shorter than 30 years, the monthly payments will be larger.

Assume that you borrow $175,000 at 5 percent over 30 years, and the required monthly payment for principal and interest is $940. The total interest expense over the life of the loan will be $163,000.

Related: What’s better in 2018? The 5/1 ARM or the 15-year fixed loan?

Borrow $175,000 at 4.5 percent over 15 years and the monthly payment will be $1,340 — a steep $400 more per month. But, the total interest cost over 15 years will be $100,000 less than the 30-year option.

In the real world, few people hold their loans for their entire terms. They sell and move, refinance, or head off to see the country in motorhomes.  But after any number of years, the buyers with the 15-year loan will have accrued more equity (wealth), increasing their likelihood of profiting when they sell.

Shop and compare

Finally, studies have shown that mortgage rates and terms can differ between lenders on average by .25 to .5 percent per day, and by as much as 1.5 percent depending on the day and program. So a .125 percent increase on a given day can be offset if you find a deal that’s .5 percent better.

Contacting a number of lenders and comparing and shopping aggressively is something over which you have control. Take it.

Verify your new rate (Oct 15th, 2018)