The other major downside to a higher mortgage rate (aside from the payment)

If you’re currently thinking about buying a home, or are somehow in a position to refinance an existing loan, current mortgage rates aren’t looking great.

Although it may not be as high as it was in the 1980s (when it averaged 18%), the rapid rise from less than 3% to 7% was undoubtedly painful.

The obvious problem is that a higher mortgage rate equates to a much larger monthly payment.

You’re paying more each month, which is undesirable and probably unaffordable.

But assuming you’re still able to qualify for a mortgage, there’s another big downside to a higher rate.

Look at the composition of your mortgage payment

  • Homebuyers tend to focus only on their total monthly mortgage payments
  • But it is important to look at the allocation between principal and interest
  • When mortgage rates are high, a large portion of the payment goes toward interest
  • When mortgage rates are low, a large portion of the payment goes toward the principal (aka repayment of the loan!)

As I’ve written before, a mortgage payment consists of four components: principal, interest, taxes, and insurance.

In short, we refer to it as PITI (see more mortgage language here).

The tax and insurance portion is mostly determined by the purchase price, while the principal and interest are determined by the loan amount and mortgage rate.

Simply put, the higher your mortgage rate, the higher your monthly payment will be, all other things being equal.

So, if you take out $500,000 (30-year fixed loan) at 7%, it will be much more expensive than the same loan amount at 3%.

In fact, it would be roughly $1,200 extra per month, which is nothing to sneeze at.

It will be difficult to qualify for the loan thanks to the high income-to-income ratio, and it will be difficult to make monthly payments over the life of the loan.

But perhaps just as important, a much smaller portion of your monthly payment will be allocated to repaying the loan.

Payment 1 at 3%: $858.02 in principal, $1,250.00 in interest
Payment 1 at 7%: $409.84 in principal, $2,916.67 in interest

For example, the down payment on a 7% mortgage would consist of a staggering $2,916.67 in interest and only $409.84 of principal.

Meanwhile, a 3% mortgage would consist of only $1,250.00 in interest and $858.02 principal.

In other words, about 40% of a 3% mortgage rate is made up of the first month’s principal. This means that approximately half of your monthly payment from day one will go toward paying off the loan.

Conversely, only about 12% of a 7% mortgage rate goes toward the principal balance in the first month. And interest accounts for the other 88%. Oh!

Here’s what’s even crazier.

It would take more than 10 years of paying off the loan at the higher rate for the principal to become equal to what it was in the first month of the loan with the lower rate.

This just gives you an idea of ​​how high interest home loan defaults are.

What you can do about it

Pay more to save interest
Loan amount: 500,000 US dollars Standard payment
Pay an additional $500 per month
Mortgage rate 7% 7%
Monthly payment $3,326.51 $3,826.51
Additional payment $0 500 dollars
Loan balance after 60 months $470,657.95 $434,861.50
Total interest over the full term $697,544.49 $445,008.69
Possible savings $250,535.80

You’ve probably realized by now that a higher mortgage rate doesn’t just mean a higher monthly payment.

It’s also more interest that is paid over the life of the loan, reducing the outstanding loan balance for many years to come.

Although this is unfortunate, there is something relatively simple you can do about it, assuming you have some extra cash on hand.

Simply pay extra for your mortgage and you can significantly reduce your interest expenses and ensure that more goes to principal rather than interest.

Using the same example as above, imagine you put an additional $500 into the principal balance every month since the beginning of the loan term.

In the first month, you’ll pay $909.84 for the principal balance, which is about $50 more than the loan’s 3% interest rate.

While you will still pay more total interest for the loan at a 3% interest rate, You can reduce your total interest expense by more than $250,000.

Your total interest will drop to about $445,000 compared to $698,000 if you just paid the loan on time.

Not quite as good as the $259,000 interest on a loan at 3%, but we’re talking about a 133% higher interest rate. So it’s still a decent win.

You can also pay off your mortgage early, by about a decade, turning a 30-year fixed loan into a 20-year loan.

In the meantime, you can look for an opportunity to do an interest rate refinance to get a lower rate, assuming rates will fall in the future.

Speaking of which, your loan balance will be a lot lower in just a few years, which could make it easier to qualify for a lower LTV, which could result in a lower rate.

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