The Impact of Interest Rates on Home Buying

In the fall of 2021, the average interest rate on 30-year fixed mortgages was just under 3%. By fall of 2023, due to Federal Reserve rate hikes to curb inflation, it was nearly 8%. Higher interest rates mean higher monthly mortgage payments and lifetime costs of a loan. They can also impact home prices and other dynamics of the housing market. Unfortunately, with housing inventory still limited and demand still high, housing affordability remains a challenge for many Americans. Buying a home in a high-interest environment isn’t ideal, but in some situations, it can be worth it. Here are some important things to consider.

The Impact of Interest Rates on Home Buying

The Federal Reserve doesn’t set mortgage rates directly, but they influence interest rates by creating targets for the federal funds rate. Banks use these to set interest rates for borrowing and lending money. When rates set by the Federal Reserve are low, like during the pandemic, borrowing is cheap—but savings interest rates are negligible.

In recent years, the pandemic and foreign conflicts led to supply chain issues, a tight labor market, and surging inflation, along with persistently high housing costs. In March 2022, the Fed began a series of rate hikes, hoping to calm hot housing markets and cool inflation, making borrowing more expensive.

This did cause home prices to stabilize or decrease in some markets. But there were also far fewer home sales as homeowners stayed put and renters kept renting, scared off by higher home prices and an increased cost of borrowing due to rising interest rates.

Mortgage Interest Rate Example

Say you bought a $350,000 home when rates were low. You got a 30-year fixed mortgage with a 20% down payment ($70,000). With a 3% interest rate, your monthly payment was $1,783.95 and your total cost of borrowing (including principal, interest, property taxes, and home insurance) is $642,221.08.

For a mortgage of the same amount and term with a rate of 7.5% under higher-interest conditions, your monthly payment increases to $2,755.58. Over the 30-year term, the total loan cost is a staggering $992,010.28. The difference is around $350,000—the price of the entire house—all because of a few interest points.

Pros and Cons of Buying a House in a High-Rate Environment

Whether you’re currently a renter or a homeowner trying to decide whether to sell and start over, consider these ups and downs of buying when mortgage rates are high.

Pros

• Home prices and interest rates could keep rising, so while rates are higher than they were a few years ago, you might get a better deal now than if you wait.
• With fewer buyers shopping right now due to higher costs of borrowing, you might have more negotiating power.
• If housing demand continues to outstrip supply, you have a good chance of quickly building equity and making money if you sell.
• You can refinance later if rates eventually decrease significantly.
• Renting isn’t cheap either; in most markets, buying may be cheaper than renting.

Cons

• Monthly payments are larger and you’re spending more on interest than principal compared to when rates are lower.
• You might be priced out of a home size or area you could have afforded previously.
• There’s less home inventory available since homeowners are reluctant to sell and lose their low-rate mortgages.
• If you own a home with a low interest rate, selling it to move means sacrificing it for a new, higher interest rate.
• When combined with inflation and all the costs of homeownership, renting may be more affordable in the short term.

How to Be Strategic About Buying a Home

A purchase as massive as homebuying shouldn’t be taken lightly, especially in an economy with inflation and steep interest rates and housing costs. As you weigh whether to buy or keep renting, here are strategies to save money.

1. Improve Your Credit

Higher credit scores indicate financial responsibility, which lenders often reward with lower rates. If you plan to buy in the near future, start making efforts to get your credit mortgage-ready so you can score the best rate possible when the time comes. Make sure to also compare rates across several lenders.

2. Explore Alternative Mortgages

Consider comparing conventional mortgages to other options, such as government-backed VA loans or FHA loans. They typically offer lower interest rates and down payment requirements.

You could also compare rates and costs of an adjustable-rate mortgage. These have fixed lower interest rates in the first months or years, then they become variable and can fluctuate. If you don’t plan to own the home for long, or you’re willing to gamble that rates won’t go up, this could be worth a look.

3. Save More for a Down Payment

You can help offset larger monthly payments caused by higher rates by saving more for your down payment. The more you put down, the lower your mortgage balance and interest payments. Some lenders also offer better interest rates for higher down payments. Plus, if you get a conventional mortgage, putting down at least 20% avoids private mortgage insurance—an added monthly cost until you build up enough equity.

4. Request a Buydown

When getting a mortgage, you can buy discount points. This is like prepaid interest that reduces your interest rate for the life of the loan. Some states also allow sellers to pay the buydown fee. There may also be types where a seller purchases points that temporarily reduce the interest rate at the start of the loan. If you’re in love with a home but current interest rates put it out of reach, inquire if the seller would consider paying for a buydown so you can afford the home.

5. Consider Compromises

If the market you desire becomes unaffordable with high interest rates, consider expanding your search radius. Perhaps there’s an up-and-coming neighborhood worth exploring, or you decide a longer commute is worth it. If not, weigh if you can live with renting in the more desirable area instead.

You might also need to reset expectations on what type of home you buy. For example, settling for a smaller home, or one that needs some eventual updates rather than the dream home you’ve been eyeing.

If you’re desperate to buy but can’t stomach the price, consider getting a roommate or use Airbnb’s room rental feature for an open bedroom. Just be prepared financially if you’re without renters or roommates contributing for a month or longer.

6. Look into Local Programs

Many cities, counties, and states have subsidized programs to make homebuying more affordable. There are requirements in areas such as income, job, type of property, and sometimes being a first-time homeowner.

Some programs make grants for down payment assistance, offer zero-interest mortgages, reserve homes for those with certain incomes, sell homes at a discount, or provide tax credits.

The Bottom Line

The Fed recently announced a series of target rate reductions through 2024, and mortgage rates have already started coming down from their recent high. But mortgage rates and home prices might still remain higher than buyers have become accustomed to in recent years.

Buying a home is the dream for many, but that doesn’t mean it’s right for every person and situation. If it’s the right path for you, use the tips above to save where you can. If it’s not yet in reach, keep improving your credit and saving your down payment. For the latter, take advantage of the positive side of high interest rates with a high-yield savings account or money market account to earn interest while saving for your down payment.

For any mortgage service needs, call O1ne Mortgage at 213-732-3074. We are here to help you navigate the complexities of home buying and find the best mortgage solution for you.