Thursday, March 20, 2008

Interest Rates Going Up

Buyers usually assume that when the Federal Reserve cuts the short term interest rate, the mortgage interest rate will also drop. It's a lot more complicated than that. The Fed's most recent cut will probably cause fixed mortgage rates to go up. Adjustable rates may go down, which is a relief for people who currently have adjustable rate mortages (ARMs), but I think most people have heard enough horror stories about ARMs that few home buyers will choose that option anymore.

Suppose you can buy a $200,000 house with 20% down at 6% interest today. Your principal and interest payment would be $959.28 per month. Suddenly interest goes up to 7%. Your P&I payment will be $1,064.48. This might be enough that you now longer qualify for a loan.

Some buyers are waiting for the market to hit bottom before they buy. Experienced investors know that it is impossible to time their purchases perfectly. If, in the hypothetical situation I described, the interest rate went to 7%, the price of the house would have to drop to $180,233 in order for the P&I to be $959.28. This would be a 10% drop in price. I think the chances of interest rates going up more than 1% are greater than the chances of property values dropping more than 10% in the next few months, especially in the under $250,000 price range where most of the sales activity is occuring.

So it's a gamble. While waiting for prices to drop, buyers may see interest rates increase to the point where their buying power is severely reduced.

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