Who Loves Cheap Money?
Updated: Dec 10, 2020
Why Low Interest Rates Lead to High Purchasing Power
Interest rates remained at historically low levels this month, with Freddie Mac pinning the average 30-year fixed mortgage at 2.87% - a decline of 78 basis points since rates began their sustained fall in March. With the Fed committing to keeping rates low through at least 2023, this unprecedented interest rate environment is a major opportunity for real estate investors. Specifically, low interest rates reduce monthly payments and increase the amount of home you can afford. As we’ll discuss, small changes in interest rates can have major effects on purchasing power.
Imagine you want to take out a $200,000 loan on a property. The table below shows how monthly payments on your loan vary depending on market interest rates. The column on the left shows the most recent date at which investment mortgage rates were equal to those in the table. Evidently, higher interest rates lead to higher monthly payments.
Historically, interest rates for investment properties have been 0.5 - 0.75% higher than those for primary mortgages, which reflects their higher risk of default. With 30-year FRMs now averaging 2.87%, we expect the interest rate for rental investment properties to be closer to 3.50%, as indicated in the table. At this current rate, you can expect to pay $898 each month. Now if the interest rate were to increase to 4.5%, the monthly payment would now be $1,013 - an increase of 13%.
Another way of conceptualizing this is to look at the max home price you can afford given a fixed monthly payment. In the example below, we assume a budget of $1,000 per month for principal and interest and an LTV of 70%, which is standard for rental properties:
At the current rate of 3.50%, this $1,000 can go a long way. With that budget an investor can obtain a max loan amount of $222,695. At 70% LTV, this means they would be able to purchase a property worth $318,136. This is higher than the $299,230 investors could afford at the end of March, and drastically higher than $238,274 in the wake of the Great Recession. Controlling for all other conditions (such as inflation), an increase in rates of 1.0% leads to a decrease in purchasing power of roughly 12%.
The graph below shows another way to visualize purchasing power in relation to interest rates.
Once again, as rates decline investors can afford higher prices. While these numbers are a simplification - for example, they don’t take into account costs like taxes and insurance - they do show the significant effect interest rates have on purchasing power. Additionally, the current low-interest rate environment has led to an increase in home prices, which will also impact the affordability of an investment.
Regardless, the current low interest rate environment has proven to be extremely desirable for investors and homeowners alike. Mortgage origination and refinance activity in Q2 broke records as borrowers looked to reduce their monthly payments or convert existing equity into cash. That peak stands out on the graph below, which tracks mortgage volume from 2005 - present:
To sum things up, low interest rates pose a great opportunity for investors looking to capitalize on lower payments. But before rushing into low-interest mortgages, you’ll want to make sure you aren’t compromising your portfolio with overly expensive investments, or those with unhealthy risk profiles. Additionally, be aware of loan terms aside from the interest rate that may affect the desirability of your loan. If you can keep these things in mind, then you’ll be putting yourself in a position to increase your purchasing power and returns.