You Decide: How can homeowners cope with high interest rates?
Published 5:21 pm Tuesday, October 3, 2023
By Mike Walden
One of the busiest times of my career as a faculty member at North Carolina State University was 40 years ago, in the early 1980s. Like now, mortgage interest rates were on the rise, making it more difficult for buyers to afford to purchase a home. To address the situation, the mortgage industry began offering different kinds of financing, such as the adjustable interest rate mortgage. I received numerous requests from all across the state for educational workshops to help people understand the pros and cons of alternative mortgages. I had overflow crowds at most of the workshops. It was some of the most gratifying teaching I ever did.
The average interest rate on mortgages today is at a 20-year high. It is also almost three times higher than a mere three years ago. This means that for every $100,000 borrowed to buy a home, monthly payments are $270 more now than they were in 2020.
So, once again, people interested in purchasing a home want to know how to cope with the high interest rates. I’ll use today’s column as a substitute for an in-person workshop to give you information and analysis for navigating today’s mortgage maze.
A simple approach to high mortgage interest rates is to hope they eventually go down. Indeed, many economists expect rates to fall next year. One strategy is to buy a home today using an expensive mortgage, but then to refinance that mortgage once rates lower. The downside is you will have to pay “refinancing fees,” which are usually between 2% and 6% of the loan amount. You would need to do the math and make sure the savings on your payments over time exceed the refinancing fees.
There are some mortgages that claim you won’t need to pay refinancing fees, but be careful. Often, such mortgages will charge a slightly higher interest rate, or they will roll the refinancing fees into the loan amount, meaning you pay those fees, but just over time instead of in one payment.
Adjustable interest rate mortgages – often referred to as “ARMs” – were introduced in the early 1980s, and they are now a common alternative. Using an ARM means the interest rate you pay can change over time, both up or down. An advantage to the borrower is that the initial rate on an ARM is usually 1 to 2 percentage points lower compared to a traditional fixed-rate mortgage. This could save you between $70 and $130 per $100,000 borrowed in monthly payments.
The big plus of an ARM is your payments decline if interest rates drop, and there is no need to pay refinancing fees as you would with a fixed-rate mortgage. But the major worry with an ARM is that your payments will rise if interest rates rise. Some borrowers don’t like this kind of risk, so they shy away from ARMs even if the ARM’s initial payment is lower.
Economists can help with the fixed vs. ARM decision by pointing out that interest rates tend to move in a predictable cycle. Interest rates usually peak at the end of a growth period in the economy or at the beginning of a recession. Rates typically hit bottom when a recession is nearing its end, or the economy is in the early stages of a growth period. Many economists think we are now near the final months of the current economic growth period and possibly at the beginning of a recession. If this viewpoint is accurate, mortgage rates should be at or close to their highest level. Based on this forecast, the best strategy would be to use an ARM now, then refinance to a fixed-rate mortgage when interest rates hit their bottom level in a year or two. But – of course – nothing is guaranteed.
If you go the route of an ARM, you should diligently read the “fine print” of the agreement. You need to know how often the interest rate can change, the limitations on changes in the rate, and the total change allowed over the life of the mortgage. The index used by the mortgage company to trigger rate changes is also important. Make sure you understand each of these elements.
A common way to lower the mortgage rate is to pay “discount points.” One discount point equals 1% of the loan amount and typically lowers the interest rate by one-fourth percentage point. Hence, you pay now to lower your mortgage payments later. You only want to consider paying discount points if you plan to remain in the home long enough that your accumulated savings in payments exceed the discount points. For most homebuyers, this means staying in the home for at least 10 to 15 years.
On any type of loan, interest rates are higher the longer you take to repay the money. One way to apply this logic to homebuying is to use a mortgage with a shorter term. The common mortgage is 30 years. An alternative is a 15-year mortgage. Currently, 15-year mortgages have interest rates about one percentage point lower than 30-year mortgages. Of course, the downside is your monthly payments will still be higher because you’re paying off the loan faster.
The last method I’ll offer to cope with high interest rates is to bring on a partner to help with the payments. With a “shared appreciation mortgage,” the lender is your partner. The lender lowers the mortgage interest rate by as much as two percentage points. In exchange, at some future date, the homeowner must pay the lender a specified percentage of the home’s increase in value since the purchase. With a “shared equity mortgage,” the homeowner contracts with a co-buyer to share in all the expenses of the home – including financing – for a certain time period. Then, at an agreed date, the homeowner must buy out the partner by paying a share of the total value of the home.
Obviously, there is a substantial risk with both of these shared-financing arrangements, which might explain why their usage has dropped in recent decades.
Buying a home is the dream of many households. But when mortgage interest rates rise, achieving homeownership becomes harder. However, there are options, although each has their own pluses and minuses. Potential buyers will have to decide which option works best for them.
Mike Walden is a William Neal Reynolds distinguished professor emeritus at North Carolina State University.