It seems like the perfect time to buy a home. In some real estate markets, home prices are still fairly low, and mortgage rates have been near historic lows for years. Right now, though, many buyers are still more interested in saving up for a down payment.
While a bigger down payment can save you some money on your home, you might be surprised at how influential mortgage rates can be when it comes to your monthly payment and your cash flow. As analysts look to next year as a time when home loan rates are likely to rise again, it's important to consider the impact of your interest rate on your monthly payment.
Home Affordability and Monthly Cash Flow
The rule of thumb for home affordability is that you shouldn't spend more than 30 percent of your monthly income on housing. If your monthly payment is more than that, you could be in danger of not having enough for your other bills. Another consideration is that a high monthly payment can result in difficulty handling financial emergencies if they arise.
Monthly cash flow is an important consideration when buying a home. While your down payment can make a difference by lowering the amount you borrow initially, mortgage rates might matter more in the long run since they impact how much you pay each month to borrow that money. Over the course of 30 years, that monthly payment can be a big deal in terms of home affordability and final cost.
Impact of Your Mortgage Rate on Your Monthly Payment
You can see the impact of mortgage rates on your monthly payment by looking at an example of a home that costs $200,000 and is paid over a term of 30 years. Let's also assume you have excellent credit and qualify for the best mortgage rates.
In the first scenario, you save up for a down payment of 10 percent. That's $20,000, reducing your loan amount to $180,000. Even though your down payment is less than the recommended 20 percent, you choose to buy now so you can get a mortgage rate of 3.75%. Using LendingTree's mortgage calculator, it's possible to see that the monthly payment for principal and interest is $834.00
What if you wait to save up enough for a 20 percent down payment? Waiting that long to get to the point where your mortgage amount is $160,000 could mean higher interest rates. You might be paying 5.25% instead. That seemingly modest increase means a monthly payment of $883.53 for principal and interest. On a monthly basis, that's an extra $49.53 – even though your down payment was higher. What are some of the things you can buy with that money? It might mean more groceries, more gas for your car, music lessons for your children, or any number of things. Nearly $50 can make a difference in a homeowner's budget, even if all you do is put that money in an account meant to help with home maintenance.
Over the course of the year, that's an extra $594.36. Over the length of the loan (30 years), that's $17,830.80.
However, if you put less than 20 percent down on a home, you'll be forced to pay private mortgage insurance, or PMI. PMI typically costs between 0.5 and 1 percent of the loan on an annual basis. On a $180,000 loan, PMI will cost between $900 and $1800 per year, or $75 to $150 per month. To remove PMI, your loan balance must reach 80 percent or less of the value of the home. On a Federal Housing Administration loan, or FHA loan, mortgage insurance premiums remain for the life of the loan.
With your 10 percent down payment, your monthly payment is now $909.00 (assuming $75 per month in PMI), which is $25.47 more per month than the example with 20 percent down and a higher interest rate. Assuming you pay PMI for five years before it's canceled, you've spent an extra $1,528.20 (versus $17,830.80 with the higher interest rate and 20 percent down).
In this example, it would be more cost-effective to puchase a home now with 10 percent down to take advantage of lower interest rates than it would be to wait until you have a 20 percent down payment and a higher interest rate. Of course, we made a good amount of assumptions, but this just goes to show how many variables can affect your monthly mortgage payment.
Ideally, you'll be in a situation where you can both take advantage of today's low interest rates and put down 20 percent. If you're not in that situation, you'll need to assess your individual financial situation and determine whether or not you should purchase a home now or wait and save up more money for a down payment.
Before deciding on a down payment, think about other factors that impact your monthly mortgage payment and your monthly cash flow. Taking advantage of low mortgage rates now might mean more money down the road.