How interest rates affect buying power

Mortgage interest rates have changed drastically over the last few years, ranging from some of the lowest rates in recent memory at the end of 2020 to the highest rates in over a decade in 2022. Understanding how these mortgage rates affect how large of a loan you can afford helps you decide if now is the right time to buy a home.

Key insights

• Higher mortgage rates mean buyers can afford less.
• Fixed 30-year mortgage rates more than doubled between December 2020 and July 2022, according to Freddie Mac.
• Even small rate increases can significantly reduce your buying power.

How do high interest rates affect the housing market?

High interest rates can have a number of effects on the housing market, including your ability to get approved for a mortgage, the supply of homes on the market and home prices in general.

Increased rates decrease buying power

Rising mortgage rates can have a significant impact on buying power. A 1% increase in rates can add hundreds of dollars to a monthly payment and make it difficult to qualify for a loan in the first place. As a result, you might be forced to purchase a less expensive home or wait until rates drop before entering the market.

Finding a home in a lower price range means you might have to compromise and look at homes that are in a less desirable neighborhood, in need of repairs or upgrades, smaller than you planned for, or without the amenities you want.

If you don’t want to compromise, you can wait until the market shifts while working on your qualifications as a borrower: You might try to come up with more money for a down payment, increase your credit score or improve your debt-to-income ratio to qualify for a better mortgage.

Less demand and lower home prices

When fewer people can afford a mortgage because of high rates, it can lead to a reduction in the demand for homes and a shift in the price of real estate.

“Homes become more expensive for buyers, and that begins to change the housing market from a seller’s landscape to the buyer’s. Buyers become pickier, take longer to make decisions, and these actions ultimately reduce demand,” said Brad Cahoone, CEO of Global Home Finance, a mortgage broker in Texas and Georgia.

In turn, sellers might need to adjust their price expectations.

“Home sellers, at some point in the buyer’s market, will need to reduce their listing prices to attract qualified buyers,” explained Cahoone. “It doesn't happen overnight, but it will happen. There is always an ebb and flow between home seller’s and buyer’s markets [as] supply and demand move up and down.”

The changes in sellers’ expectations due to reduced demand can benefit buyers who are able to afford a mortgage even with the higher interest rates.

“Reduced demand means less competition, which can create opportunities for buyers that were previously unable to get into contract due to excessive competition,” Megan Micco, a mortgage broker for Compass in the San Francisco Bay Area, said. “As interest rates have increased and buyer demand has cooled, competitive offers no longer need to be entirely non-contingent, which provides additional protection for people purchasing property.”

On the other hand, when interest rates are at all-time lows, sellers can often choose from several offers, and many buyers begin to make non-contingent or all-cash offers.

How are interest rates set?

Many things make up a mortgage interest rate — some are within a borrower’s control, and some depend on the lender and the overall economy. Factors that go into determining mortgage rates include:

• Inflation
• Federal Reserve rates
• Overall economic conditions
• Origination costs
• The borrower’s finances
• The property’s price and location

» MORE: Mortgage APR vs. interest rate

How does a 1% rate increase affect what you can afford?

A slight rate increase might seem minor, but this small increase in your monthly payment can add up over time and affect your buying power.

If you look at a borrower with a monthly income of $4,500 and a debt-to-income ratio of 36% who makes a 20% down payment, even a quarter of a percent increase can mean they’ll be able to afford roughly $12,000 less over the course of a fixed, 30-year mortgage. With a 1% increase, the price of a home they can afford drops by more than $45,000.

The table below shows the difference in buying power for mortgages with rates between 4% and 5%. Even when the monthly payment is the same, the maximum price of a home the borrower can afford goes down significantly when the interest rate increases slightly.

» MORE: Mortgage rate lock: how and when to lock in your mortgage rate

Bottom line: Is now a good time to buy a house?

Mortgage interest rates change daily, and picking the right time to buy a house depends in large part on your personal financial situation.

Overall, if you can afford a mortgage with the current interest rates and you find a good deal on a house you like, you might consider now a good time to buy a house. If the house you want is outside of your budget because of your current finances and the market today, it might be a better idea to wait until the rates are lower or save up more money to increase your down payment.

You may also consider an adjustable-rate mortgage for a lower initial rate or buying now and refinancing if rates drop.