How Rising Interest Rates Increase Mortgage Costs

Quick Answer

With mortgage rates on 30-year, fixed rate loans rising over 5%, the cost for mortgages is significantly higher, which may make homeownership unaffordable for many.

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The Federal Reserve plans to raise interest rates several times in 2022, leaving house hunters facing a grim reality: Rising mortgage rates are adding to the cost of buying a home.

Your mortgage interest rate directly impacts your monthly payment, as well as your loan's total cost over the life of the loan. Say you have a $300,000 mortgage loan with a 3.5% fixed interest rate. In this case, your payment will be $1,655.47, and you'll end up paying a total of $484,968.26 in principal and interest to pay off the loan.

By contrast, let's take that same $300,000 mortgage and see what happens when the interest rate is its current 5.51% rate instead of 3.5%. A roughly 2 percentage point jump may not seem like much, but it results in higher monthly payments of $2,013.58 and $613,889.90 in principal and interest.

Let's go over some of the cost increases homebuyers (and those with adjustable-rate mortgages, also called ARMs) may expect due to rising interest rates—and steps you can take to save money.

How Federal Reserve Rate Hikes Impact Mortgage Loans

When someone says "the Fed is raising rates," it simply means the Federal Reserve is changing its target for the federal funds rate. That's the rate the Federal Open Market Committee (FOMC), the board of the Federal Reserve, advises commercial banks to charge when they lend money to other banks.

Generally, banks add 3% on top of the federal funds rate when setting their prime rate for their customers. Currently, the federal funds target rate is 1.50% to 1.75%, and, consequently, the prime rate stood at 4.75% in July 2022.

Of course, if you have a fixed-rate mortgage, the rising rate will have no impact on your loan: Your interest rate and the monthly payment will remain the same. However, rising interest rates could raise your monthly payment if you have an ARM, and fixed mortgage rates may be more expensive for new home loans.

Rate Increase Leads to More Costly Mortgages

We can track recent interest rate trends to see how federal rate increases lead to higher mortgage rates, monthly payments and loan amounts.

Let's rewind a year to July 2021, when the federal funds rate was firmly planted at 0% to 0.25%. At the time, the average mortgage rate on a 30-year fixed mortgage was 2.88%, according to data from Freddie Mac.

One year later, after a series of rate hikes, the federal funds target rate currently sits at 1.50% to 1.75%, causing the average mortgage rate on a 30-year fixed mortgage to jump over two and a half points to 5.51%. In June, the Fed raised interest rates by 0.75 percentage point, its largest hike since 1994, in an effort to cool down the hottest inflation rate in 40 years. The impact of 2022's interest rate hikes is trickling through the mortgage industry.

The recent rise in mortgage rates along with an already hot real estate market is driving up monthly payments on new mortgage loans. Principal and interest payment for the median U.S. home is up almost $600 (44%) from the beginning of 2022, and $865 (79%) higher than before the pandemic, according to real estate data firm Black Knight Data and Analytics. Looking strictly at interest rates, a 2% rise in interest rates adds $115 to your monthly payment for every $100,000 of a 30-year home loan.

Qualifying for a New Mortgage May Be More Difficult

Higher monthly payments are likely to make it harder for people to qualify for home loans they could have otherwise afforded before the recent rate hike, even if the home price is the same. That's because a higher home price skews your debt-to-income ratio (DTI), a major factor lenders consider during the mortgage approval process. Generally, lenders want your housing payment to account for no more than 28% of your gross monthly income and all of your monthly debt payments to represent no more than 36% of your gross income.

What Can You Do to Save on a Mortgage?

The good news is it's still possible to buy a house, even with interest rates on the rise. Doing so, however, may require you to make some cost-saving moves, such as:

  • Putting down a large down payment: The more money you put toward your down payment, the more you can lower your loan-to-value (LTV) ratio. Having a low loan amount compared with the home's market value makes you appear less risky to lenders, which may qualify you for a lower interest rate.
  • Getting a no-PMI loan: Saving up a down payment of at least 20% is challenging, but it may lower your monthly mortgage payment and help you bypass the need for private mortgage insurance (PMI). The cost of PMI typically ranges from 0.5% to 2% of your total loan amount, and you'll usually make PMI payments monthly.
  • Getting a shorter-term mortgage: Shorter loan terms, such as 15 or 20 years, often come with lower interest rates than longer loan terms. By opting for a shorter loan term, your monthly mortgage payments may be higher, but you could save on interest charges over time.
  • Shopping around and comparing rates: One easy way to save money on your mortgage is by getting quotes comparing rates from multiple lenders. According to the Consumer Financial Protection Bureau (CFPB), you can save $300 a year on average just by shopping for more than one rate quote.
  • Improving your credit score: Your credit score is one of the biggest factors lenders consider when setting the interest rate and fees for your loan. Generally, the higher your credit score, the more likely you'll qualify for a lower interest rate. Taking the time to improve your credit before buying a home could lower your monthly mortgage payments.

If you're planning on purchasing a home in the near future, consider checking your free Experian credit report and credit score. You'll gain a clearer understanding of your current credit profile and help you identify any steps you might take to improve your credit to get the best mortgage rates and terms available.

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