As a consumer, one should understand that higher payments are not the only effect of rising interest rates. It is also important to understand the inverse effect of interest rates on home values. Typically, when rates move down, home prices tend to increase or appreciate. When rates move up, home values typically move down or depreciate. In a low-rate environment, money is cheaper, resulting in the ability to secure a larger mortgage and afford a more expensive house. Sellers also have the ability to sell their homes for a higher amount.
Let’s look at the pros and cons of an increasing rate environment from the perspective of both future homebuyers and those who are looking to refinance their existing property:
Pros of Increasing Rate Environment
Consumer Homebuying:
The ability to afford homeownership is reduced and fewer people can afford to buy. This results in increased supply and lower demand, which ultimately drives home prices (values) down.
The increased supply results in a “buyers’ market,” where the buyers have more homes to choose from, offers can be lower and buyers have more time to assess their options. Sellers become more desperate to sell. The buyers are no longer in a position where they need to hurry up and make an offer with the fear that they will lose the home if they don’t react quickly enough. Purchases in a “sellers’ market” (the opposite of a buyers’ market) typically result in a higher rate of buyer’s remorse, due to jumping into the transaction too quickly.
If the homebuyer has the ability to buy in cash, i.e. they do not need to take on mortgage debt and are not affected by rate increases, this can prove to be a very opportune time to buy a home if they can wait until the values have depreciated.
If you buy in a buyers’ market, there is potentially more opportunity for future upside, i.e. opportunity for increased equity, because you bought the home for less than it was recently valued at. This is not always the case and can also take years to materialize.
IMPORTANT: Rate / Home Price Equilibrium:
While future homebuyers may get excited reading this, they need to face the reality that there is typically a rate/home price equilibrium that may shelter some of the advantages here.
Below are a few examples showing the equilibrium between depreciation and increased rates. We will keep the monthly payment constant and apply both depreciation and rate increase:
Current Home Price:
$500,000 | 20% down = $100,000 | Rate = 2.875% 30 year fixed | payment = $1,659.57
If values depreciate by 5%: $475,000 | 20% down = $95,000 | Rate = 3.278% 30 year fixed | payment = $1,659.57
If values depreciate by 10%: $450,000 | 20% down = $90,000 | Rate = 3.713% 30 year fixed | payment = $1,659.57
If values depreciate by 20%: $400,000 | 20% down = $80,000 | Rate = 4.700% 30 year fixed | payment = $1,659.57
This is showing that even though the values of homes are depreciating and you can buy the home for less, considering the interest rates are increasing in parallel, you are still paying the same amount per month for the house, regardless of whether you buy today or tomorrow.
Consumer Refinancing:
None in my opinion
Cons of Increasing Rate Environment
Consumer Homebuying:
The net effect of increased rates will immediately affect buyers’ mortgage payments, however, it may take longer for the value of homes to be affected, i.e. depreciate. This can potentially put the buyer in a double-edged sword position, where rates are higher, yet the values of homes did not decrease yet. Buyers who are actively looking for a home need to be aware of this potential issue.
Consumer Refinancing:
Increased interest cost due to higher rates.
Reduction in overall equity, due to depreciation.
Increased loan-to-value ratios (loan amount/value), resulting in higher credit risk and therefore higher interest rates.
Less available equity to access as cash.
Neither Pro Nor Con, But Worth Considering:
If you are an existing homeowner and you are planning on selling in an environment where the rates are increasing and therefore the values are decreasing, it may be advantageous to sell your home and then rent until the trend reverses. The thought here is, if you sell in a down market and buy in a down market, you are netting less in net proceeds from the sale, while running the risk of continued equity loss with continued depreciation of the subsequent home. This is easier said than done.
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