Ask Brian is a weekly column by Real Estate Expert Brian Kline. If you have questions on real estate investing, DIY, home buying/selling, or other housing inquiries please email your questions to [email protected].
Question from Regina in Oklahoma City: Hi Brian, last weekend I visited my sister Jenny. Both of us want to buy our first house and over a few cold beers, we got to talking about what we need to do to make it happen. My sister and I are close, but we don’t have any other family that we trust to give us advice. Without boring you, I’ll just say that dad has been out of the picture since we were kids, and we love mom, but she’s never been good with money. To keep it short, neither of us has even bought a new car. Now we’re talking about a house that will probably cost $250K. After our visit last weekend, Jenny talked to a girlfriend at work who said we need to start by getting preapproved for a mortgage. Her friend said to call a local real estate agent and ask for the name and number of someone that can help us shop for a mortgage. My sister did call an agent and was told she needs to act fast because interest rates are going up and the longer we wait, the more expensive buying a house is going to be. The agent said that interest rates will soon be above 5%. Now I think that I can get to my question. How could a 5% interest rate be a big deal? I have a credit card with an interest rate of 14%. An interest rate of 5% sounds like a good deal to me.
Answer: Hello Regina. WOW! I’m glad you asked because I’m sure many others want to know how to find the best mortgage rate for first-time buyers. But everything you should know is too much to cover in one article. So, I’ll try to help you find a good place to start.
The agent is correct that interest rates are going up and it will make it much more expensive to buy a house. You cannot compare a 14% credit card with a 5% mortgage. Thankfully, we haven’t had 14% mortgage rates since the early 1980s when inflation was terrible. But any increase in mortgage rates is a big deal when buying a $250,000 home.
The reason there is so much difference between credit card and mortgage interest rates is that the credit card loan is a much higher risk. If you stop paying your credit card bill, no one is going to take the shirt off your back that you bought with the credit card. Credit card loans are unsecured loans. The only guarantee that you’ll repay the money is your signature when you make the purchase. You pay high interest on credit cards because the lender is taking a much bigger risk than with a mortgage that is secured by the home you live in. A mortgage is secured by your home. If you miss too many mortgage payments, the lender will take your home away in foreclosure to sell it and recover their money. Less risk for the lender means they can charge lower interest and stay in business.
Regina now let’s look at why a small increase in the interest for a mortgage is a much bigger deal. A few months ago, mortgage rates were about 2.8%. On a $250,000 mortgage for 30 years, the monthly payment would be $1,027 (not including taxes and insurance). At 5%, the monthly payment would be $1,342. That is a $315 increase in the monthly payment. If you stay in the house for 10 years, the higher interest rate will cost you an extra $37,800. That $315 a month is a big deal that can prevent many first-time buyers from qualifying for a mortgage. Compare it to a credit card with a $15,000 balance that goes up from 14% to 16%. The credit card monthly payment goes up from about $177 to $201. Most people can afford the extra $24 a month for the credit card much easier than the $315 increase for the mortgage. It’s about both the interest rate and the amount of money borrowed.
Now, how does a first-time buyer find the best mortgage? This is where things get much more complicated because there are many variables. The basic process begins by asking questions like what type of mortgage is best for you? A 30-year fixed rate mortgage is the most common for first-time buyers. However, you should learn what else is available like adjustable rate mortgages (ARMs) that become more popular when interest rates are higher but are riskier for the homeowner because your monthly payments could go up in future years. The starting interest rate is often lower than a fixed rate to make it easier to qualify for a mortgage today. You’ll want to learn a lot more about ARMs before making this decision.
Another alternative to consider is paying points to discount the mortgage interest rate. Discount points are fees borrowers pay to reduce the interest rate on their mortgages. One point is 1% of the loan amount, which typically reduces the mortgage rate by 0.25%. For example, one point on a $250,000 mortgage would cost you $2,500 to lower the interest rate from 5% to 4.75%. That $2,500 is in addition to your down payment and does not pay down the price of the house. It only pays for a lower interest rate so that your monthly payment is lower. It can take years for your lower monthly payment to recover the $2,500 you pay to lower the interest rate. The break-even period varies depending on the loan amount, the cost of the points, and the interest rate. It's often seven to nine years. If you don't plan to have the loan for that long, it's a good idea to skip the discount points.
Regina, I hope that makes some sense to you and at least gives you a place to start asking questions. I think loan types like 30-year fixed and ARMs, along with discount points are basic places to start asking questions when interest rates are going up. However, many other variables could work better such as 20 or 15-year fixed rate mortgages. You will also want to learn about other options like FHA loans that can require as little as 3.5% down. You also want to know about other costs that come with a mortgage like property tax, homeowner insurance, and an HOA fee if your home is part of a homeowner association.
Also, don’t automatically accept the first mortgage preapproval offered without shopping around.
Readers will have different ideas about how to find the best mortgage as interest rates rise. Please leave a comment if you have a better idea about what Regina should do.
Our weekly Ask Brian column welcomes questions from readers of all experience levels with residential real estate. Please email your questions or inquiries to [email protected].