Buying a Chicago home has become more expensive, and it isn’t just home prices at work. While Chicago median home prices increased by 4.5% in September*, mortgage interest rates are becoming a big part of the story. Here’s why!
As of October 25, 2018, the average interest rate for a 30-year fixed-rate mortgage was 4.86% with 1/2 point, according to Freddie Mac’s weekly mortgage lender survey. A year ago, the same mortgage held a rate of about 3.94% with 1/2 point. An approximate 1% difference in rate environments may not sound like much. But when you’re talking about interest on $260,000 or more, over a 30-year period, even a modest rate increase can affect you.
Your mortgage rate doesn’t just affect your mortgage payment. It also affects your debt-to-income ratio, (DTI) which is an important calculation lenders use to determine home affordability.
DTI is calculated two ways: front-end DTI, and back-end DTI. The front-end considers how affordable your new mortgage payment will be on its own. To figure this out, the lender looks at your projected mortgage payment against your gross monthly income.
For example, if your new mortgage payment is $1,400 a month, and your gross monthly income is $5,000 a month, then your front DTI ratio is 28%. ($1,400 divided by $5,000 = 0.28).
Back-end DTI compares all of your monthly debt payments, plus your new mortgage payment, against your gross monthly income. Using the example above, if you had a car payment of $250 a month, in addition to the mortgage payment, your back DTI ratio would be 33%. ($1,400 mortgage + $250 car payment = $1,650 total monthly debt payments. $1,650 divided by gross monthly income of $5,000 = 0.33).
Even under the most generous mortgage underwriting standards, your back-end DTI cannot exceed 50% of your gross monthly income. Most lenders want to see it at 43% or less.
Here’s where higher rates trip up home buyers on the DTI ratios. If you qualified for a $1,400 mortgage payment while rates are trending around 5%, that would allow you to borrow about $260,000.
But if your offered rate becomes 5.5%, you could only borrow about $246,500 to keep your mortgage payment within that $1,400 limit. At 6% interest, your couldn’t borrow more than $233,500 in order to keep your mortgage payment at the $1,400. That’s a $26,500 reduction in purchase power!
Please remember, our math is for example purposes only. Your lender and your specific mortgage program may allow different DTI ratios from the ones we’re using. The interest rate you qualify for could be better or worse than our examples. The point we’re trying to make, is that any upward climb in interest rates can reduce your home buying power.
When interest rates are climbing, you may want to prepare some counter-strategies:
- Buy a less expensive home
- Make a larger down payment
- Pay points to buy down the mortgage interest rate
- Increase your income (lender may require 2 years of work history to count a second job or new position)
- Reduce or pay off outstanding debts
- Improve credit score to attract better mortgage rate offers
Rising interest rates may have raised the bar, but they haven’t blocked the path to home ownership. A good mortgage lender will help you find the best financing strategy for your home purchase! We’ll be happy to refer you to trustworthy, local lenders in Chicago and the Northwest Suburbs. Just ask!
StartingPoint Realty – serving first-time home buyers since 2004!
StartingPoint Realty serves first-time home buyers throughout Chicago and the Northwest suburbs. Get an introduction to home buying by attending our free home buying seminar! There’s no sales pressure and no obligation.
Always feel welcome to contact us for help with your Chicago home buying questions!
Ryan Gable Broker/CEO Starting Point Realty
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* City of Chicago median home prices increased 4.5% on a year-over-year basis, September 2018 vs. September 2018, per Illinois REALTORS statistical data.