What is the Effect of Rising Interest Rates ?

By Dian Hymer

During the first week of June this year, interest rates on home mortgages were higher than they have been in nearly two years. According to Freddie Mac, an organization that buys mortgages from banks and other loan originators, the average rate on a 30-year fixed mortgage was 7.41 percent, the highest since September, 1997. Some in the mortgage industry think that rates will plateau at this level. Others believe that rates are going to as much as 9 percent. Only time will tell. But under either scenario, it, like the period during which we have enjoyed the lowest mortgage rates in 30 years, may be drawing to a close.

One of the first effects of higher interest rates is that the refinance market slows down. Homeowners who want to refinance their current mortgage into another one with a lower rate will table their refinance plans when rates rise. They'll be back in the market when interest rates drop again.

Home buyers are more adversely effected by rising rates. Higher interest rates make it harder for buyers to qualify for financing. When rates rise too high, buyers have to scale back their expectations and buy more affordable, less expensive properties. Marginally qualified buyers are most profoundly affected by rate increases. If you barely qualify for a $200,000 mortgage at 6.75 percent, you probably won't qualify for the same size mortgage with interest rates 1/2 to 3/4 percent higher.

One alternative way to keep housing affordable when interest rates rise is to switch from fixed to adjustable-rate financing. During the first week in June this year, the average initial interest on a one-year adjustable-rate mortgage (one where the interest rate is adjusted annually) was 5.85 percent.

Some buyers are nervous about taking an adjustable-rate mortgage (ARM) when rates are rising. Even though most ARMs limit how high the interest rate can go during the life of the loan, home buyers often feel more comfortable with stable monthly housing payments. For such buyers, a hybrid mortgage, also called a fixed-period ARM, is another way to keep financing more affordable when rates rise.

A hybrid mortgage is one that has a fixed interest rate for a period of time, usually for 3, 5, 7 or 10 years. After the fixed interest rate period, the interest fluctuates for the remaining term of the loan. The initial fixed interest rate on a 10-year fixed ARM is approximately 1/2 percent lower than it is on a 30-year fixed-rate loan. With a 10-year fixed ARM, it's likely that the homeowner will never experience rate fluctuations because statistics show that most homeowners either sell their home and pay off the mortgage or refinance within 5 to 7 years.

First Time Tip: While you might expect higher interest rates to slow the real estate market down, the opposite can also occur. In April of this year, when rates started to inch up, a home buying fever hit Americans who bought at a pace that was the second highest level on record. With increased competition to buy before rates go higher it makes good sense to get pre-approved for a mortgage. A pre-approved buyer can close quickly. This may make a big difference to a seller.

The Closing: When interest rates are rising, buyers are wise to consider locking in an interest rate. When you lock in a rate, the lender commits to making you the loan at a certain interest rate, even if rates rise further, as long as you close within a specified time frame (usually 15 to 90 days).