Here’s why 7% mortgage rates are much more detrimental to buyers now than they were 20 years ago
Understanding the Basics of Mortgages
In order to comprehend why a 7% mortgage rate is worse for buyers now than it was 20 years ago, you first need to understand the basics of how a mortgage works. This financial tool is designed to lend money to individuals seeking to invest in real estate, with the property itself acting as collateral. The interest rate applied corresponds to the amount you will repay over and above your initial loan.
The rate you get can hugely impact your financial life for many decades, so it’s important to appreciate how much the lending environment has changed over time. To do this, we need to delve into the concept of ‘real’ versus ‘nominal’ interest rates, inflation rates, income growth and more.
Placed alongside historical context, it soon becomes clear why a higher rate could have larger consequences today. Let us walk through the following scenario: You take out an 100,000-home loan with a 30-year term.
- At a 3% rate, you would pay approximately 422 monthly on principal and interest.
- At a 7% rate, that leaps to approximately 665.
- This means that over the life of the loan, a 4% difference in interest equates to roughly 87,000 more to be paid back.
- It does not consider any increases on insurance or taxes during that time period only the principle and interest.
- If incomes don’t increase in tandem with higher interest rates, homeowners could end up house rich but cash poor.
- This leads to financial stress and hardship when it comes to meeting other important financial commitments.
Exploring Differences Between Current And Past Lending Environments
Next, let’s explore why the same mortgage rate would affect buyers differently depending on the era in which they are obtaining their loan. The major factors to consider are average income levels at that time, what portion of that income was earmarked for housing, and inflation.
Having established some of the key reasons why mortgage rates matter so much, you might now be wondering why a 7% rate today is worse than it was 20 years ago. Let’s dive into this question headfirst, by exploring the current lending climate, comparing how things stand today with what they were like two decades back.
Remember, mortgage rates had an average of around 7-8% in the late 90s. Consider that in 1999, a person who earned the median American salary could expect to commit approximately 30% of their income toward mortgage payments on a median-priced home. Today, that same person with the same income, facing the same mortgage rates would need to spend closer to 50% of their paycheck.
- Median income has not increased as fast as housing costs.
- The cost of living in general, including education and healthcare costs, have outpaced income growth.
- This means more strain on the borrower’s overall budget, making high mortgage rates even harsher.
- While interest tax deductions can provide some relief, it makes little difference if cash flow is already tight.
- This phenomenon does not consider any potentially limited savings the individual might have already had.
- These combined factors make servicing a high-interest mortgage today a significant setback compared to years ago.
Decoding Real and Nominal Interest Rates
An interesting facet of financial economics is the concept of real and nominal interest rates. A nominal rate is the percentage lenders quote when you apply for a mortgage. But this doesn’t tell the whole story. There’s also what’s known as the “real interest rate,” which adjusts the nominal rate to take inflation into account.
You see, in periods of high inflation, interest rates tend to rise while the buying power of money decreases. To compensate for this, lenders may increase their nominal interest rates to maintain profitability. The ‘real’ rate effectively reveals how much you’re paying or earning after accounting for inflation, and this is where context matters.
Let’s backtrack to the 1970s when inflation was running rampant. If a lender offered a mortgage with a 7% rate but inflation was at 6%, the real rate was actually only 1%.
- Inflation diminishes the magnitude of the real interest rate.
- High inflation erodes the purchasing power of future payments back to the bank.
- It means the higher the inflation rate, the lower the real interest rate, all else being equal
- This is why many people could afford mortgages with seemingly high-interest rates during periods of hyper-inflation.
- The nominal vs. real distinction becomes less relevant in an environment of low inflation or deflation.
- However, it can have a profound impact on borrowing costs during inflationary periods.
Navigating Through Diverse Inflationary Environments
Inflation does not remain static or predictable. Rather, it fluctuates over time due to a variety of economic factors. Let us examine in detail how quickly rising prices change the environment for mortgage borrowers, especially in relation to this discussion about 7% mortgage rates being worse now than earlier.
During times of high inflation, your fixed-rate mortgage essentially becomes cheaper each year in real terms because lenders cannot adjust the rates alongside increasing prices. When inflation is high, as it was in the late 70s and early 80s, a higher mortgage rate won’t bother you too much.
Unfortunately, we are currently living through a prolonged period of low inflation rates, an environment that doesn’t lower the real cost of your mortgage over time. A 7% rate now “hurts” more because its real impact on your wallet is significantly greater.
- During high inflation, fixed interest debt becomes less expensive over time.
- Low inflation rates mean high-interest debt remains high throughout the loan term.
- This also implies one can expect little relief from inflationary depreciation on a high-interest mortgage in today’s environment.
- A higher portion of your principal remains outstanding for longer in a high-interest low-inflation environment.
- This ensures a steeper climb to building equity in your home especially in the early years of the mortgage.
- Conversely, during periods of high inflation, despite a high-interest rate, you may build equity faster due to rising home values relative to remaining loan balance.
Effect Of Increased Front Load
Another important facet of the higher mortgage rates seen today versus two decades ago involves the concept of ‘front-loaded’ payments. Mortgages are generally structured so that a larger part of your early payments goes toward interest rather than reducing your overall loan balance.
The problem arises when high rates excessively front load payments and thus greatly slow down the pace at which borrowers can accumulate equity in their homes. This increased front loading means homeowners might spend years mainly paying off interest without establishing significant ownership stakes.
If we consider a 100,000 mortgage with a normal 30-year term, going from a 3% to a 7% interest rate nearly doubles the total amount of interest paid over the life of the loan. That’s significant.
- Higher rates mean slower accumulation of home equity.
- Situations can arise where homeowners can face a ‘negative equity’ situation, meaning they owe more than the house is worth.
- If home values decline, those with little equity in their homes are especially at risk.
- In such situations, selling one’s home won’t even cover the remaining mortgage balance, sporting a big financial blow.
- It also becomes harder to refinance your mortgage and take advantage of lower future interest rates if you’ve not built up enough equity.
- This might trap homeowners in their high-interest loans for many years.
Understanding Wage Growth Impact
Wage growth, or the lack thereof, can dramatically alter a borrower’s ability to manage mortgage payments. In the past, high wages coupled with high inflation worked in favor of home buyers despite higher interest rates. However, recent years have witnessed sluggish wage growth, making high rates more difficult to navigate now.
Let us consider this – average wage growth was approximately 5% per annum in the 1970s when inflation was at similar levels. This meant that incomes were increasing rapidly, keeping pace with expense increases and high-interest costs. But today, nominal annual wage growth is around 3%, which doesn’t come close to offsetting potential increases from rising interest rates.
The bottom line: Unless income levels grow quickly in tandem with higher interest rates, any increase is likely to result in a disproportionate burden on homeowners.
- Rapid wage growth in the past absorbed high-interest rates in comparison to today’s sluggish income increases.
- Until the early 1980s, median household incomes generally increased along with interest rates, relieving the mortgage burden
- But since then, consistent wage growth has been absent whilst housing prices have escalated, creating a potentially
- This means more of a household’s income goes toward mortgage payments, restricting other forms of spending and saving.
- The stagnant wage growth complicates matters when home prices increase by a larger margin than incomes do.
- The combination of slow income growth and fast-rising housing costs can lead homeowners into financial distress particularly if the interest rate environment worsens.
A Glance At The Housing Market
The current state of the housing market also plays a tangible role in magnifying the impact of an elevated mortgage rate. Simply put, houses are much more expensive now than they were two decades ago. This trend compounds the problems created by high mortgage rates and compressed wage growth.
The updated median US home price is approximately 265% higher than it was two decades ago. Therefore, even if wages and interest rates had remained constant over this period (which of course, they haven’t), new homebuyers today would find themselves needing to borrow much more, and thus pay back exponentially more in interest.
Given this landscape, it’s clear that for a first-time buyer today, negotiating the 7% rate on their large loan will rightfully seem a lot more daunting than it would have been for a homebuyer two decades back.
- The current high-price environment intensifies the challenges posed by higher interest rates.
- High home prices mean you’ll probably need to borrow more for your mortgage, which subsequently raises your overall repayment.
- Greater principal amounts mean greater interest paid over the life of the loan.
- Bear in mind, higher borrowings also mean raising a larger down payment to avoid mortgage insurance.
- High prices add another dimension of pressure for home buyers looking to enter the housing market presently.
- This issue throws light on further affordability issues today’s potential homebuyers face apart from grappling with higher interest rates.
|Situation Two Decades Ago||Situation Now|
|High inflation, which often reduced the real impact of high mortgage rates||Period of low inflation, which doesn’t significantly erode the cost of your mortgage over time|
|Rapid wage growth could cope up with high-interest rates||Slow wage growth means people have less income to cover higher interest costs|
|Home prices were considerably lower, implying smaller loan amounts||Huge increase in house prices, leading to bigger loans and larger repayments|
When you step back and look at the broader picture, all these points help clarify why a 7% mortgage rate has such different implications today compared to two decades ago. From stagnant wages and spiraling home prices to the front-loading of mortgage interest and lower inflation, a multitude of conditions compound to make such an interest rate much more intimidating now.
Remember, this illustration uses the historical average, and everyone’s financial scenario is unique. Therefore, consider it as a guiding principle rather than an absolute rule. While rates are just one factor to consider when taking out a mortgage, understanding how they work can help you make informed decisions as a potential homeowner. Similarly, awareness about long-term trends can guide your expectations and prepare you for the complexities of homeownership tomorrow.
Mortgages are probably the most significant financial commitment most people make in their lives. As such, it’s worthwhile investing effort into understanding how they function as well as how the wider economic context impacts them.
- *Always research thoroughly before committing to a mortgage.*
- Remember that the interest rate isn’t the only factor to consider.
- Analyze all parts of your loan agreement before signing up.
- Assess factors such as ongoing fees, repayment schedules, and flexibility of terms.
- Consider the general market conditions.
- Be sure to consult with professionals in order to fully understand your commitment and potential risks.
And remember, finance is always about more than just numbers. It’s about making choices today that set up a better future. So don’t shy away from asking questions, seeking advice, and studying up – it could save you thousands in the long term.