What Role do Interest Rates Play in Purchasing Power?
When buying a home, your purchasing power is based on your housing expense to gross income ratio. Interest rates are a factor in determining your housing expense. The higher the interest rate the lower the loan amount you would qualify for. Conversely, the lower the interest rate the higher the loan amount you would qualify for. Let's look at a few examples:
Joe and Mary are considering buying a home. Based on their gross income, they qualify for an $800,000 loan on a purchase of a $1,000,000 home with 20% down. They have been quoted a rate of 6.5%
$800,000 loan at 6.5% = $5,057 (principal and interest payment)
Let's assume rates increase to 8.0% while they are deciding whether or not now is the right time to buy. Joe and Mary now qualify for:
$689,150 loan at 8.0% = $5,057.
This is a decrease of $110,850 in loan amount or $138,563 loss in purchasing power!
Joe and Mary want to wait because they believe prices of homes may go down about 10%. They are still willing to put 20% down. Assume the $1,000,000 home drops 10% in value to $900,000. The loan amount would be $720,000. Rates are up to 8.0% during that time.
$720,000 loan at 8.0% = $5,283 (they now exceed their ratio for qualifying - remember they qualified at $5,057.)
Joe and Mary must now put $30,850 more down to qualify. In other words, they must reduce their purchasing power to approximately $861,000!
They cannot buy this home in this example even with the reduction in value.