Here’s how homebuyers can handle rising mortgage rates [Video]
It’s a race against time for homebuyers as mortgage rates keep rising.
The rate on the 30-year fixed-rate mortgage rose to 5.78% this week from 5.23% the previous week, marking the biggest one-week increase since 1987. Year-to-date, the average rate added more than two and a half percentage points, exacerbating an already difficult market for buyers.
“For every 1% increase in mortgage rates, your borrowing power drops by about $50,000,” Scott Sheldon, branch manager at New American Funding, told Yahoo Money. “In other words, the higher the rates, the lower your purchasing power.”
For any homebuyer in the market, that means you need to be strategic and explore all possible ways to maintain a cap on your mortgage rate. Here’s how.
Lock in your rate — but not for too long
Once you’re contracted to buy a home, lock in your mortgage rate in case rates rise further, Jeffrey Ruben, president of WSFS Mortgage, told Yahoo Money.
“If borrowers haven’t locked in their rate, they’ll have to qualify based on the most expensive monthly payment,” Ruben said, “which could lead to the need to increase the amount they’re putting on a home or , in the worst case scenario, the loan application could fail.
Rate locks typically last 30 days, but some lenders offer up to 45 or 60 days, according to Ruben.
“We can also lock for longer periods, but longer lock times come at a cost,” he said. “With increased volatility and rising rates, longer lock-in periods are extremely costly and impractical.”
Qualify for a higher rate
Protect yourself against rising rates by prequalifying at a higher rate than the current rate, according to Sheldon.
“I recommend qualifying at 6% to buy a house,” he said. “That way, if rates go up to 6%, you qualify. If rates hold at today’s levels, you would have the advantage of being able to continue to perform on the home purchase because that you qualified at a higher rate from the start.”
If you have the money, buy a better rate. Borrowers can purchase cash back percentage points up front to secure an interest rate that supports a lower mortgage payment. And in today’s market, buying points is a must.
“Today, a pointless 30-year fixed mortgage rate is 6.75% to 6.78% with a 20% decline,” Sheldon said, a full percentage point above Freddie Mac’s average rate. “People are in shock because now paying points is the norm.”
There is no single formula for calculating the cost of a point. It can be 0.5% to 1% of the loan amount, for example, Sheldon said, depending on a number of factors such as market conditions, the amount of your down payment, your credit score and occupancy of the property.
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How much a point lowers your rate also varies.
For example, in a normal market, one point would get half a point or three-quarters of a point on your mortgage rate, according to Sheldon. “But it’s not a normal market,” he said, “with a point down only an eighth of a percent today.”
Your credit score also plays a role. If you have good credit, expect to pay half to one and a half points to get a fair mortgage rate, with bad credit scores paying at least two points. Those with at least a 760 credit score and a 30% down payment will need to purchase the fewest points.
“The majority of owners don’t fall into that category,” Sheldon said.
Pay off the debt
The debt-to-income ratio (DTI) is the percentage of your monthly pre-tax income that goes to pay your estimated mortgage payment, credit card bill, and other debt payments. It is calculated by dividing your total monthly debt payments by your income. The higher the ratio, the higher your mortgage rate is generally.
To reduce DTI, pay off any of the following before getting a mortgage:
“Pay any of these debts, ideally those with the lowest and highest balances [monthly] payments, is a solid rule of thumb,” Sheldon said.
Put more down
If your DTI is already low and you have extra cash, add it to your down payment to help lower both your mortgage rate and your monthly payments. But if your DTI is still high, you’ll get more for your money by paying extra money on your debt than on your down payment, Sheldon said.
Get a co-signer
Having a co-signer on your home loan could lower your mortgage rate if the co-signer has a good credit score and low debt. The key to a co-signer is to add to the income side of the DTI calculation without increasing the debt side too much. It is important that the co-signer also understands what he is assuming.
“Co-signing means they’re obligated on the loan in the same way as the primary borrower,” Sheldon said. “And they are just as responsible for making the payment as the primary borrower.”
Consider an MRA
Another option is an (ARM). Unlike fixed rate mortgages which have the same interest rate for the life of the loan, the rate for ARMs can change over time. The rate resets after a specified period, reflecting current interest rate conditions, resulting in higher or lower monthly payments.
At present, these are attractive because the introductory rate for ARMs is lower than the rate for the 30-year fixed mortgage – the most popular option among buyers. This week, the rate for the five-year ARM was 4.33%, compared to 5.78% for the 30-year fixed mortgage.
“If rising rates have impaired a buyer’s ability to borrow, an experienced lender may recommend switching them from a fixed rate mortgage program to an adjustable rate mortgage program in the short term,” Kenyon Hunter, real estate broker associated with Evolution Ave Group RE, told Yahoo Money. “That way, if rates go down in the future, they could refinance to a fixed rate mortgage.”
“Of course,” Hunter added, “looking for low-cost homes is also an option.”
Ronda is a senior personal finance reporter for Yahoo Money and an attorney with experience in law, insurance, education and government.