Interest rates have had a substantial impact on the overall affordability of a home. With mortgage rates on the continual rise, it’s time to think creatively about how we can minimize our long-term costs and make our homes more affordable in the short term. Did you know that a 1% interest increase adds a little over $600 a month in cost on a $1,000,000 loan?
From a lender’s perspective, there are a variety of ways to lower the impact of mortgage rates like rate buydown and Adjustable-Rate Mortgages (ARMs). I’d advise speaking to a lender about the best options for you.
Ever heard the phrase “marry the home, date the rate”? This is a common Realtor phrase to help buyers understand that rates have the option of being temporary. The benefit of a fixed-rate mortgage is you lock in a rate so if it goes up, you maintain the lower rate, and if it goes down, you can simply refinance. Long-term, refinance is a great solution for the temporary issue of higher rates. However, it doesn’t really help you now. So, what can you do to lower the impact of higher rates right now?
The quick and easy solution is to increase your down payment. To understand the impact of increasing your down payment, let’s look at dueling scenarios:
20% Down Scenario:
Using a 30-year fixed mortgage at 6.5%
Purchase Price: $1.2M
Down Payment: $240k
Mortgage Amount: $960k
Monthly Payment: $6,067.85
25% Down Scenario:
Using a 30-year fixed mortgage at 6.5%
Purchase Price: $1.2M
Down Payment: $300k
Mortgage Amount: $900k
Monthly Payment: $5,688.61
The difference seems pretty straightforward: pay the extra $60k and reduce your monthly payment by $379. While impactful, that by itself might not seem worth the additional investment. There is another hidden benefit though; because your loan amount is less, you’ll pay less in interest over the lifetime of the loan.
Your additional $60k investment is yielding a return every year. After 13 years, you’ll have earned your $60k back. I’m sure some of our investment-savvy readers will ask the question: “What about the opportunity cost of not having that money? You could invest it elsewhere.” You’d be right, there is an opportunity cost as there is with not increasing your down payment. The opportunity cost of that is not having the additional cash each month to invest how you chose. The Average Annual Return for that down payment investment is 7.58%!
The historical average return on the stock market is around 9%. As long as inflation and interest rates remain high, we shouldn’t expect anything near that mark anytime soon. This only adds to the attractiveness of that additional 5% down “investment”. I’ve created this handy calculator to help you understand the return on your excess down payment investment no matter the interest rate or purchase price.
Once you start playing around with the calculator you realize a few things. The lower the interest rate, the less return on your investment. The higher the interest rate, the higher the return on your investment. It makes perfect sense, doesn’t it? As interest rates rise, it becomes more costly to borrow money so the less money that you have to borrow, the more benefit (Return on Investment) you’ll receive. That benefit, of course, is a lower payment and lower interest cost over the life of the loan.
But wait, it gets better! You still have the refinance option in your back pocket. Let’s say after 5 years, the rates go down to 5%. You would have paid $57,501 in principle toward your loan. When you refinance, the new loan amount would be $842,499.
If you refinanced…
30-year Fixed Rate
Interest Rate: 5.0%
Mortgage Amount: $842.5k
Monthly Payment: $4,522.72
20-year Fixed Rate
Interest Rate: 4.8%
Mortgage Amount: $842.5k
Monthly Payment: $5,467.46
In both scenarios, you are better off.
With a 30-year refinance, you’d restart the clock (and amortization schedule). At the end of the 30 years, you would have paid $1,064,738 in interest payments (1st loan: $279,246 2nd loan: $785,491). The refinance saves you $78,405 in cumulative interest payments over the life of the loan. With the refinance, you lower your monthly payment by $1130 a month ($5653 - $4523).
With a 20-year refinance, you maintain a similar payment ($186 cheaper). Interest rates are lower due to the shorter term. You’d pay $394,452 less in interest payments. You’d also reduce your payment timeframe by five years!
The moral of the story is that paying a higher down payment is a great way to lower your loan exposure and save money. You’ll receive a significant return on your investment while also maintaining the opportunity to refinance down the line.The higher the payment, the larger the return on your increased down payment investment.
This means that you can purchase a home at a more affordable price than when the market was peaking (but interest rates were low) and use that additional cash to increase your down payment therefore lowering your monthly payment (and interest cost) on the loan. When you factor in those strategies, it may just be a better time to buy than when prices were high and rates were low. More on that in another blog.
If you can navigate these uncertain times with creative tricks and realize that these interest rates are a temporary hurdle that you can overcome, opportunities for deals are out there. Reach out so we can talk through how an increased down payment can help you achieve your real estate goals.
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