"Goals are dreams with deadlines" -- Diana Scharf

Thursday, April 4, 2013

Why Interest Rates Matter

Alexander Hamilton, first U.S. Treasury Secretary

If you know nothing else about Alexander Hamilton, you probably know that he was killed in a duel with Aaron Burr (remember this "Got Milk" commercial?).  But did you also know that he was the first United States Secretary of the Treasury?  Two of his major fiscal policies included creation of the U.S. Mint and a central bank for the emerging nation.  Although the “First Bank of the United States” later became defunct, I think it would be fair to say that Alexander Hamilton was responsible for building much of the financial structure that still exists in the United States government.  Another fun fact: Hamilton was considered quite handsome in his day.  Personally, I think he resembles Mel Gibson – nothing wrong with that. 

Anyway, on to the real content of this post: interest rates

After a March meeting of the Federal Open Market Committee (FOMC), the Federal Reserve released a statement regarding its anticipated treatment of interest rates.   The statement was vague, but the Fed announced its intention to keep interest rates low for the immediate future.  The Fed also specified several benchmarks that it will use in order to determine the appropriate time to discontinue its current “easy money” policies.  As I understand it, so long as inflation does not increase significantly, the Fed will wait for unemployment to dip below 6.5% before it considers raising interest rates.  The Fed projects that interest rates will remain low throughout 2013 and 2014, but these low rates will not continue indefinitely.  I will be thrilled once unemployment percentages return to a more manageable level.  In this most recent recession, several loved ones were victim to layoffs that lasted anywhere from two months to six years, and I know their experience was not unique. 

However, as aspiring home owners, we wish that interest rates wouldn’t increase as a result of the economic rebound.  Since Mr. W. and I would like to buy a house within the next 3-4 years, we’re very interested in interest rates.  These predictions have led me to ask: Precisely when will interest rates rise?  How much will they rise? What are interest rates going to look like in 2016 and 2017? And most importantly to us, How will interest rates affect the cost of purchasing a home?

Unfortunately, I can’t answer the first three questions.  If you happen to own a crystal ball, feel free to share your economic forecasts with those of us non-magical folks.  Thanks.

The fact of the matter is that lower interest rates decrease the incentive to have a large down payment.  I've been wondering whether it would be better to take advantage of current borrowing conditions (ie, buying sooner) or save as much as possible for a down payment (ie, buying later).   

Although I can’t predict the future, I can estimate how interest rates will impact the cost of purchasing a home.  I’m a bit of a numbers geek, so I spent some time crunching numbers and playing around with various mortgage scenarios.  In the analysis that follows, I’ve concentrated primarily on the total cost of the down payment, principal, interest, and PMI (if applicable).  I’ve assumed a 30-year mortgage since it is the most common choice.   I’ve also assumed purchasing a $350,000 home because this will probably be a good ballpark when Mr. W and I start looking for a starter home: two- or three- bedroom, one-bath single family home that is in a good school district, but needs a bit of TLC. 

This is what I learned: Interest rates matter.  Truly, they do.  In fact, getting a low interest rate could save more money than having a hefty down payment.  That conclusion is a bit scary, for two reasons: 1) it flies in the face of traditional wisdom that you should only buy a home once you have saved at least 20% for a down payment, and 2) we have control over how much we save, but we can’t control interest rates (unless you’re the chair of the Federal Reserve, which I’m not).

In a perfect world, we could buy a home with a low interest rate and standard down payment.  Let’s take a look at this “perfect world” scenario.     


In this perfect world, let’s suppose we buy a $350,000 home with 20% down and a 3.5% interest rate.  In my analysis, this is Plan A/Option 1.  This means that our loan amount is $280,000, for which we’ll have a monthly mortgage payment of $1,257.  Over the life of the mortgage, we will pay $172,637 in interest.  The total cost to buy the home is $522,637.  At 3.5% interest, it costs us $.617 to borrow a dollar (this is the “interest/principal ratio”). 

Now, let’s suppose that interest rates start to increase.  Plan A/Option 2.  At 4%, it would cost us $551,235 to buy that same $350,000 home.   The cost to borrow a dollar at 4% increases to $.719.  Now let’s consider Plan A/Option 4.  At 5% interest, it would cost us $611,116 to buy a $350,000 home, and the cost to borrow a dollar would be $.933.  That’s not a pretty picture.   Obviously, the best option is to buy the home at 3.5% interest.  No big surprise there.   

Unfortunately, life isn’t perfect.  We don’t currently have $70,000 saved for a down payment and there aren’t many houses around here that are less than $350,000.  So let’s move on to another scenario, “Plan B”.  

In this group of scenarios I’ve assumed that, for every year we wait to buy a home, we save an additional 5% towards the down payment.  I’ve also assumed that interest rates increase by approximately .5% on an annual basis. 


In Plan B/Option 1, we put 10% down and are able to get a 3.5% interest rate.  Since we didn’t have 20% for a down payment, we must pay PMI of $142/month for the first 6.9 years of our mortgage*.  The monthly mortgage payment, before PMI, is $1,414.  Including PMI, the total cost to buy our home would be $555,954.  We'd pay just under $12,000 in PMI.  The cost to borrow a dollar (interest plus PMI, divided by loan principal) is $.654.  That’s not so bad, right?

Now, let’s suppose that we wait until we have 20% for a down payment, by which time interest rates have increased to 4.5%.  This is Plan B/Option 3.  We wouldn’t have to pay PMI in this scenario, which is great.  However, the total cost to buy our home would be $580,739.  The cost to borrow a dollar would be $.82.  Even though we put twice as much down on the house, and we didn't pay PMI, we would still end up spending almost $25,000 more to buy the same home.  And that's just the difference of 3.5% versus 4.5% interest.  And now let’s suppose we decide to really pinch our pennies and are able to put 30% down on the home.  Plan B/Option 5.  It takes us two years to save the extra cash, by which time interest is a not-so-nice 5.5%.  We would be paying $605,790 to buy a $350,000 home, and the cost to borrow a dollar would be a whopping $1.04.  You mean I have to pay more in interest than I’ve borrowed?! Yikes.  Somehow that feels like highway robbery.   Paying PMI is often stigmatized, but in this scenario it might be the best option. 

You might look at Plan B and wonder, “J.W, do you actually expect to get a 3.5% interest rate if you’re only putting 10% down?  Isn’t that wishful thinking?”  Perhaps.  I think it would depend on our credit scores as well as our debt-to-income ratio.  In both of these categories, I believe Mr. W and I would qualify for a low rate from lenders…but I could be wrong.  And you might also wonder whether interest rates would really increase at .5% per year.   Maybe that’s too steep an increase, although it wasn’t so long ago that mortgage rates were 4.75% (I remember when my parents refinanced their house from 5.375% to 4.75%.  I think that was in 2010).  Both of these would be fair criticisms, so let’s look at a third set of scenarios, “Plan C.”

In “Plan C,” I’ve assumed that we would qualify for a 3.75% loan if we were to put 10% down on a house.  As with “Plan B”, I’ve assumed that for every year we wait to buy a home we can save an additional 5% towards the down payment.  I’ve also assumed that interest rates only increase by .25% per year.    


In Plan C/Option 1, we buy the same $350,000 house with 10% down and a 3.75% loan.  Much as in Plan B/Option 1, we pay PMI of $142/month for 7.2 years*.  Our monthly mortgage payments are $1,459 before PMI.  Including PMI, the total cost to buy the house is $572,420, and the cost to borrow a dollar would be $.706.  If we delay buying a home until we have 20% interest, we would no longer pay PMI, but interest rates would be 4.25%.   This is Plan C/Option 3.  The total cost to buy the home would be $565,875, and the cost to borrow a dollar would be $ .771.  In this scenario, we can see why having a larger down payment is financially beneficial.  Now, let’s suppose we wait two years longer and are able to squirrel away enough for a 30% down payment.  Plan C/Option 5.  Interest rates are now 4.75%.  The total cost to buy the home would be $565,093, and the cost to borrow a dollar is $.878.  In terms of total cost, this is incredibly similar to Plan C/Option 3.  Plan C is intriguing because there is such a small difference in cost between Options 1-5. 

Of course, there are several additional financial considerations to purchasing a home that should be taken into account.  To keep this post from becoming even longer (are your eyes glazing over, yet?), I'll share those considerations in another post.  

All in all, this exercise didn’t leave us with any “Ah-ha!” moments.  We still don’t know exactly when it will be the right time to buy a home.   What we did learn was that it’s expensive to borrow money.   We now understand why some folks insist on paying cash for their homes.  We also learned that we should pay attention to interest rates.  For now, we’re not rushing into buying a home.  For several reasons, we know that now is not the right time for us.  But depending what happens with interest rates, the right time could be sooner than the 3-4 year goal we laid out in our plan.  Until then, we’ll continue to save for a home in the hopes of being ready to buy when we decide the time is right.

For those who are saving towards a home, would you ever consider putting less than 20% down? 

*Explanation on PMI calculation: For purposes of these calculations, PMI is included until 23% equity is established.  Lenders are required to remove PMI once 22% equity is established and if all mortgage payments have been made on schedule.  However, the process to remove PMI from the mortgage requires an appraisal and may take several months, so 23% equity has been used in this analysis.  PMI calculations assume that the home value remains consistent with the purchase price. 

**Disclosure: As a reminder, I'm not a financial advisor or CFP.  I've also never worked in the mortgage or loan industry.  The content of this blog is not intended to be used as financial advice, but is simply my perspective on what will work best for my household.


  1. We have a few rental properties are would love to buy another one right now. However, we don't really have the time to mess with it...BUT current interest rates make the possibility very attractive. I also wish I knew what interest rates would be in a few years!

    As far as your house goes, I would save 20% if it were me. I paid PMI on the house I live in and it was a huge waste of money. The PMI is gone now thankfully!

    1. Hi Holly, thanks for your comment. I always like to hear the perspective of someone who has "been there, done that," especially when it comes to such major life decisions.

      I can imagine that investment properties take quite a bit of work. We've had several problems with our apartment (leaks, plumbing, etc), and it makes me glad I'm not a landlord. I know the rental properties can be a great investment for the landlord, but sometimes it's nice to pick up the phone and let someone else deal with the hassle (and the expense!)

  2. I have an FHA loan (I put 3.5% down and got a 3.25% interest rate Feb 2013 on a $290K house) and my loan officer told me the PMI is automatically removed at 22% paid off. I pay $300 a month in PMI! Yikes! Thankfully I should be able to pay extra on my mortgage to get rid of it sooner. Also I read online that they recently changed the rules of a FHA loan, and PMI is now required for the length of the FHA loan so I got mine just in time as my PMI is still able to go away. I am not sure about other loan types but I thought I'd share my experience. I know there are a few other loan programs that dont require 20% down but I don't know if those are changing their PMI requirements as well.

    1. Thanks for your perspective on FHA loans. I'm glad you got your loan before the new FHA regulations took effect. I looked into FHA loans very quickly, and it seems like, with the new treatment of PMI, they end up costing more in the long run.

      I'm looking forward to seeing how your home renovations progress!

  3. Awesome analysis! Seriously, these are just the numbers I've been meaning to run for months now. And I wouldn't have done it as well as you. I'll be discussing these with the Mrs. later to see what options seem most realistic, but we're in a very similar boat as you two. Where's that freaking crystal ball when you need it?!

    1. Thanks, Johnny. I'm so glad this was helpful. Plan D: We're going to take a bunch of our savings and buy a crystal ball instead!

  4. Wow, you did a lot of work. I put 20% down because I didn't want to pay PMI. I was able to because I live in a town where housing is affordable. B and I thought about moving back to his hometown of Seattle, but the real estate prices are just too expensive. Are there factors other than the interest rate that would makes you guys want to buy a house sooner than your planned timeframe?

    1. I'd definitely love to avoid paying PMI, if possible.

      I think the primary reason we might buy a home sooner than our planned timeframe is that housing prices are likely to increase again. In our preferred town, real estate was prohibitively expensive before the latest recession. Now, prices have actually dropped to the point where there are $350,000 homes on the market. I have a hunch that, in another 3-4 years, those same homes will be back in the $425,000-$450,000 price range. There are other towns where we could buy a home, but this one has a lot of benefits (top notch schools, proximity to Mr. W's parents, proximity of public transportation, walkability, etc). I'm just not sure we'd be willing/able to pay $450k for a starter home that we might outgrow in a few years.

    2. I see, I do think interest rates will probably rise in the next 3-4 years. Should that be the case, maybe you can look into paying points to lower the interest rate. The advantage is that it lowers your interest rate. The big negative is that it would be a mini down payment you'd have to worry about and the opportunity cost of not having that money to invest. For me, I preferred paying 20% down in exchange for a lower monthly payment. Yes, I'm out a big chunk of money at the get go, but my payment is low enough that I have money left over at the end of the month to build up a cash reserve. Psychologically, that just works for me.

    3. This is a great suggestion. I like the idea of paying points to lower the interest rate...even though it means we may have to wait a little longer to build up that down payment. It's definitely another option to consider.

  5. Wow, this is super interesting, and I'm impressed by all these calculations! We're in a very similar boat - our goal is 20% down payment, but I'm nervous that before we get there we'll be priced out. I do know we are NOT READY this year, but maybe next year we should start taking a harder look at our options before our lease is up. Our decision is also complicated by the fact that we love Brooklyn, and don't want to move out just yet!

    Zillow.com has become a frequently visited website for me, though. It's dangerous. But so far I've only seen one place that we really liked AND was in our (anticipated) price range in our target area, and it's already sold!

    1. We share the exact same concern over housing appreciation. I know what $350,000 will buy me today...but have no clue whether those same houses will be $350,000, $375,000, or $450,000 when we're ready to buy. Even so, we don't want to rush into things or buy a house before we feel ready.

      I can completely understand wanting to stay in Brooklyn for a while. It must be a wonderful experience to live in such a vibrant neighborhood. My husband and I will occasionally say, "Wouldn't it be great if we could live in NYC for a few years?" We know it would delay our goals, but it might be worthwhile. For the time being, it's just not possible with our jobs since we both work in the suburbs.

      I'm addicted to Zillow.com and Realtor.com, too! And any time we walk past a house for sale, I have to stop and look at the brochures tacked to the "For Sale" signs.

  6. Nice comparison! My take-away from this, is that it's far too expensive to buy a house :(
    I wouldn't have said this is geeky at all, but that's coming from someone who spent a whole evening making a similar rent vs buy excel spreadsheet!

    1. Yep, buying a house sure is expensive. And I didn't even include closing costs in my calculations, since they wouldn't really be impacted by the other factors in this analysis.

      Thanks for your comment! And that rent vs. buy spreadsheet sounds like it'd be right up my alley : )