Understanding the Impact of Interest Rates on Mortgage Costs

Interest rates play a crucial role in determining the affordability of mortgages. They directly influence the overall cost of a home loan and the monthly payments that borrowers need to make. When interest rates are low, the cost of borrowing decreases, making it more affordable for homebuyers to purchase homes and for existing homeowners to refinance their mortgages. Conversely, higher interest rates increase borrowing costs, making it more expensive to buy or refinance a home.

How Do Interest Rates Affect Mortgage Costs?

Mortgage interest rates have a direct impact on housing affordability. Lower rates mean lower monthly payments, while higher rates result in higher monthly payments. For example, in September 2020, when average mortgage rates were down to 2.90%, the average monthly mortgage payment was $1,620. By September 2023, when average mortgage interest rates climbed to 7.31%, mortgage payments increased to an average of $1,934 a month.

It’s important to note that rate changes do not affect existing fixed-rate mortgages, which have the same interest rate and monthly payment for the entirety of the loan’s term. However, new fixed-rate mortgages and refinance loans are impacted by rate changes. Adjustable-rate mortgages (ARMs) are also affected by rate changes throughout the loan’s term.

Is the Federal Reserve Expected to Cut Rates in 2024?

The Federal Reserve has signaled that it will cut its target rate three times in 2024, resulting in a 0.75% rate cut by the end of the year. Most economists anticipate that any rate cuts won’t happen until the second quarter of 2024 at the earliest. If the Fed follows through on these rate cuts, it will mark a significant reversal from the aggressive cycle of rate hikes that began in March 2022.

When mortgage rates drop, borrowers benefit from lower borrowing costs and monthly payments. For example, if mortgage rates drop by 0.75%, you could save $750 in interest annually for every $100,000 you borrow, or $22,500 in interest charges over a 30-year term.

How Federal Reserve Rate Cuts Affect Mortgages

Banks typically set their prime rate by adding 3% to the federal funds rate. As of February 2024, the federal funds target range is 5.25% to 5.50%, and the prime rate is 8.50%. While the Federal Reserve doesn’t set mortgage rates, its actions do influence them. For example, mortgage rates climbed significantly during the Fed’s rate hikes in 2022 and 2023.

Rate Cuts Could Make Mortgages More Affordable

If the Federal Reserve lowers the federal funds rate, mortgage rates could follow suit. We’ve already begun to see evidence of this trend, with lenders adjusting rates in anticipation of the expected Fed actions. In December, when the Fed first projected rate cuts in 2024, mortgage rates declined sharply, in part due to these projected cuts.

Lower mortgage rates would be welcome news for new homebuyers who’ve been sidelined by high mortgage interest rates. Homeowners with ARMs or home equity lines of credit (HELOCs) could also see their rates and monthly payments drop.

Mortgage Approval May Get Easier

Reduced mortgage rates would result in lower monthly payments, making it easier for borrowers to qualify for a new home loan. A lower payment decreases your debt-to-income ratio (DTI), a major factor home lenders consider when qualifying you for a new mortgage. Lenders usually don’t want your total monthly debt payments to exceed 36% of your monthly income, with 28% allocated for your housing payment.

Is It Better to Buy Now or Wait for Rates to Fall?

Buying a home now is a viable option if you can comfortably afford the monthly mortgage payment, maintenance costs, and taxes at today’s interest rates. After all, you can always refinance later to secure a lower mortgage rate and payment.

Additionally, if mortgage rates continue to fall, home prices could rise. Many people have been unable to afford a home due to high interest rates. If rates drop, more homebuyers could purchase homes, and the increased demand could drive up home prices.

On the other hand, a rate decline could bring more homes to the market, easing competition. According to Zillow, 80% of existing mortgages have interest rates below 5%. Homeowners locked in these historically low rates in 2021 before rates escalated. If rates fall, more homeowners may be willing to sell if they can secure lower interest rates on their next house. More home listings could ease the current supply shortage and help curb rising prices.

Trying to time the market could be a feeble exercise since the housing market and the Fed’s policy moves are often unpredictable. As such, consider the affordability of any home purchase and your willingness to refinance later for a lower rate as primary factors in your decision.

Guidelines to Make Your Home Purchase More Affordable

Improve Your Credit

Lenders tend to extend their best rates to borrowers with better credit. Reduce credit card balances, bring any late payments current, and pay all your debts on time to begin improving your credit scores.

Save for a Down Payment

The larger your down payment, the lower your loan-to-value (LTV) ratio—the amount of money you need to borrow versus the home’s current market value. Lenders typically view borrowers with lower LTVs as less risky, which could result in a lower interest rate. You could also eliminate private mortgage insurance (PMI) on a conventional mortgage with a 20% down payment. PMI is usually added to your monthly mortgage payment and typically equals 0.5% to 2% of your total loan amount.

Lower Your DTI

Lenders take a close look at your DTI to gauge your ability to afford a new mortgage loan. Most lenders require DTI ratios below 36%, but some may allow up to 45%. Some Federal Housing Administration-backed home loans allow DTIs up to 50% if you have large cash reserves.

Opt for a Shorter Loan Term

The 30-year fixed-rate mortgage is the most popular type of mortgage but usually features higher interest rates than shorter loan terms for 15 or 20 years. If you can afford the higher payments of a shorter-term mortgage, you may save significantly on interest charges over the life of your loan.

Make Sure Your Credit and Finances Are in Good Shape

If you’re considering buying a home, make sure your financial situation and credit are squared away to take advantage of potentially lower mortgage rates. Pay down debts to lower your DTI ratio and save for a larger down payment. Shore up your credit by reviewing your credit report and credit score for free with Experian. Address any issues you find and take proactive steps to improve your credit fast.

For any mortgage service needs, call O1ne Mortgage at 213-732-3074. Our team of experts is here to help you navigate the mortgage process and secure the best rates available. Don’t wait—reach out to us today!