Higher Interest Rates Make It Harder to Qualify for a Mortgage. Here's Why

Could high interest rates price you out of buying the property of your dreams.

Mortgage interest rates have been steadily increasing this year. And despite a recent drop, rates remain above 5% and could go higher in the coming months. 

Higher rates can obviously have a big impact on how much your mortgage costs. But they can also have another adverse consequence for would-be home buyers. In many cases, it becomes harder to qualify for a home loan when rates have risen.  

Here's why that's the case.

Why do higher rates make qualifying for a loan harder? 

Higher rates make qualifying for a loan more difficult because of lender restrictions on how high your monthly payments can be relative to your income. And when interest costs rise, your monthly payment goes up.

Most lenders look at two key numbers when approving your loan -- and setting your interest rate. They are the front-end debt-to-income ratio and the back-end debt-to-income ratio. The first refers to your housing costs relative to your gross income. And the back-end ratio takes a look at all your debt (including housing costs) and compares it to gross earnings. 

Typically, lenders apply a 28/36 rule when it comes to these ratios. Your housing costs, including your mortgage interest, mortgage principal, taxes, and insurance can't exceed 28% of your income. And your total debts including housing can't exceed 36%. While there are some exceptions, you want to stay below these numbers to get the best rates and stand the best chance of being approved.

When interest rates go up, though, monthly payments become a lot higher so it becomes harder for buyers to follow the 28/36 rule needed to qualify. If you've added an extra $200 to your monthly payment, for example, then you may exceed the allowable limit to borrow. 

What can you do about it?

The most obvious solution to making sure you can still afford a mortgage is to borrow less. If you take out a smaller loan, your monthly payment is going to be smaller. You'll pay less interest and principal each month, so even though your rate is higher, you will still keep your debt-to-income ratios below the allowable limits. 

You can borrow less either by buying a home that doesn't cost as much or by making a larger down payment so you are paying for more of the home in cash rather than with a loan. Either of these options can be a great way to ensure that higher rates don't price you out of your home purchase. 

There are other options too, such as looking into mortgages you can still qualify for. Some government-backed loans, for example, tend to have higher debt-to-income ratios. And adjustable-rate mortgages may have lower starting interest rates than fixed-rate loans, which would reduce monthly payments potentially to an amount you can qualify for. 

Unfortunately, government-backed loans tend to come with high fees and ARMs are risky loans because your payments can go up over time since your interest rate can adjust. While it may be tempting to explore these solutions if you're having a hard time qualifying for a home, it's best to avoid them -- even if that means you have to wait to buy a house or look for a cheaper property that you can easily get a fixed-rate loan to buy.