Ever since the end of the housing boom in the mid-2000s, homeowners have benefited from some of the lowest mortgage rates in decades. Efforts from the Federal Reserve to stimulate economic growth held rates down, and that made it much more affordable for mortgage borrowers to get the financing they needed either to purchase new homes or to refinance their existing mortgage debt.
More recently, though, the Fed has started moving to reverse its past accommodative monetary policy by raising interest rates. June's quarter-point push higher marked the third increase in just six months and the fourth since the central bank's first move in late 2015. In response, the mortgage market has seen prevailing lending rates move higher as well. Current and would-be homeowners should take a close look at several factors that are becoming more important for mortgage borrowers in the current rate environment, and it's important to do so quickly to avoid the potential negative impact of further rate changes.
1. New homebuyers need to consider affordability
Rising interest rates make it harder for new homebuyers to get affordable mortgages. For instance, if a prospective buyer can afford to borrow $300,000 on a 30-year mortgage with a rate of 4%, a rate increase to 5% will leave that buyer only able to afford a $267,000 mortgage. If you're shopping in a real estate market that's extremely strong, then it's in your best interest to move forward expeditiously with the buying process and get a low rate locked in. That way, you won't have to downgrade your prospects if rates rise further.
If the real estate market where you're looking for a home is weaker, however, rising rates can sometimes work to your advantage. If most buyers have to use mortgage financing, then high rates can depress home prices. You won't necessarily save on your monthly payments, but spending less upfront can lead to more sizable capital gains down the road when it comes time to sell your home. Look closely at market conditions in your particular location, and you should get a better sense of whether it will pay to wait or to move to buy quickly in anticipation of higher mortgage rates.
2. Adjustable-rate mortgage borrowers have another chance to switch to a fixed mortgage
Mortgage borrowers who took the risk of an adjustable rate mortgage over recent years have been rewarded handsomely, because sustained low rates have kept their monthly payments from rising. In many cases, the savings have been substantial compared to what mortgage borrowers would have paid with a fixed mortgage.
With rates finally on the rise, however, homeowners should look closely at what's likely to happen with their adjustable rate mortgages and consider a switch to a fixed mortgage. Short-term rates are already up a full percentage point over the past year and a half, and rates on 15-year fixed mortgages are on average lower than what you'll pay for a 5/1 adjustable rate mortgage. Looking more closely at locking in makes sense, especially if you believe further rate increases are coming soon.
3. Shortening the length of your loan has pros and cons
One popular strategy that many have used lately is to refinance an existing loan with a shorter-length mortgage. By choosing a 15-year mortgage rather than a 30-year loan, you'll pay three-quarters of a percentage point less right now, and you'll save tens of thousands in interest over the term of your mortgage loan.
Picking a shorter loan has drawbacks. A 15-year mortgage requires you to make larger monthly payments than a 30-year mortgage, making them less feasible for borrowers who are already stretching to cover their monthly bills. Moreover, securing cheap financing for 15 extra years can be worth the higher interest cost for many borrowers, especially if you can earn more money from investing the difference between the monthly mortgage payments than you pay due to the higher rate. From a cash flow perspective, many borrowers feel more comfortable keeping their payment obligations low in order to have greater flexibility to manage their finances.
The trend toward lower interest rates lasted for more than 30 years, but we've already seen signs that a dramatic reversal could finally be here. To protect yourself and your home, smart mortgage strategies can make a huge difference by taking advantage of opportunities while steering clear of potential pitfalls.