Effect of Changing Interest Rates on Loan Amount
When you apply to a lender for a mortgage, you’re not so much applying for a total dollar amount as much as you are a payment. Lenders want to see that you’ll be capable of making the payments that come with a mortgage. Principal and interest are the two components of a mortgage payment. That’s why interest rates play a critical role in how much home you can afford to buy.
When a lender asks you to fill out a loan application, they’ll gather information that such as credit history, employment history, bank deposits, and investment accounts. Of particular interest will be your income and expenses. In order to prevent homebuyers from getting into a home they cannot afford, guidelines have been set requiring borrowers and/or their spouse to qualify according to set debt to income ratios. For example, FHA backed loans require that a borrower’s mortgage debt-to-income ratio be no more than 31%:
Total amount of new house payment (principal, interest, taxes, insurance, HOA, etc) = $1000
Borrowers gross income (including spouse, if married) = $3500
Mortgage debt-to-income ratio = $1000/$3500 = 28.6%
In this example, the borrower(s) have sufficient income to afford the home at the prevailing interest rates. What would happen though if interest rates were to go up? The house payment above represents a home valued at $170,000 with an interest rate of 3.7%. Now let’s look at that same home but with an interest rate of 4.7%. The house payment would become $1108/mo and the mortgage debt-to-income ratio would be 31.6%. With just a 1% bump in interest rate, the borrower wouldn’t qualify for the same home!
As a rule of thumb, for every 1% increase in the mortgage interest rate, a borrower loses $10,000 in buying power. If you’re already at the maximum debt-to-income level for a home you’re trying to buy, ask your bank about a rate lock. If interest rates start to rise, the home you thought you could qualify for last month may now be out of your reach.