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Mortgages, Lattes & Rising Rates

Photo by Tierra Mallorca on Unsplash

The Federal Reserve Open Market Committee (FOMC) has just raised its interbank borrowing rate above zero percent for the first time since 2009. The decision sends a strong signal the U.S. economy no longer requires life-support. It also means consumers will face higher interest rates on everything from student loans and car payments to mortgages and credit card balances.

So should we rush to lock-in low rates now?

No. Even a 1 percent rate increase raises the monthly payment on a $100k mortgage by just $49, and rates have only risen 1/4 of a point. Fed Chair Janet Yellen has testified before Congress she favors a “gradual approach to policy normalization” grounded in data. In other words, rate increases will occur as the economy improves, but only gradually. To better understand the impact of rising rates letʼs run several scenarios on the mortgage calculator at Itʼs easy to use and allows multiple inputs like rate and term. It also breaks down annual principle and interest amounts, enabling us to estimate after-tax cost.

Our base case considers a 30-yr fixed rate mortgage of $150k, since Federal Reserve data indicates a current median U.S. mortgage principle balance of $155,000. We also assume a 20% down payment, zero points up-front and a FICO credit score of 740. At the current national average rate of 3.90 percent, the monthly payment equates to $708. This is the amount a potential borrower would owe the bank each month, plus insurance and taxes (which we omit because of variance across municipalities). If rates rise an additional 1/4 point to 4.15 percent, the payment rises by $21 to $729, or about $0.70 per day. If you can afford a latte every morning at Starbucks (a tall costs $2.95), you can afford a 1/4 point rate increase. In fact, even if rates rise a full percent over the next year, the incremental amount per day is $2.80… still less than your latte.

While most of us can probably absorb rising rates in the near term, interest costs over time present a far greater challenge. As an example, the 30-year fixed mortgage of $150k at 3.90 percent generates total interest charges of $104,700. This is in addition to paying back the bankʼs original principle loan of $150k. Thatʼs a lot of latte. By contrast, a mortgage term of 15 years cuts interest costs in half to $48,365. True, the monthly payment jumps to $1,102 because principle has to be repaid 15 years sooner, but the interest savings is nearly a third of the original principle amount. Imagine what you could do with $48,000 more in your checking account 30 years from now… not to mention what you might have made investing those funds over the same period.

Bottom Line: Recognize rates are rising. When considering a mortgage, think less about what you can afford today and more about building wealth for tomorrow. Manage for the long term, and cut back the latte.

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