We have a young client that's looking to buy his first house. And as we all know, interest rates have been historically low but are starting to rise again. When he first started looking, rates were at 3.5%. Now they're at 4.5%. One per cent doesn't seem like much, does it? Let's see what difference it makes.
Assuming The Numbers
Let's assume for our buyer that he purchases a house for $150,000. We'll ignore taxes and insurance because these will be constant in this example. We just want to see how the interest rate affects the numbers. Our buyer is young and is looking at a 3-BR, 2-BA house. He shouldn't need to move for quite a while, even after getting married and having kids. But let's assume he stays in it for 7 years which, according to the National Association of Realtors, is the average time between moves.
Crunch Those Numbers
Looking at the amortization chart, a $150,000 loan at 3.5% interest amortized over 30 years will be $673.50 per month. So let's say he's really into paying down this loan and pays $674/month. On the other hand, a loan of $150,000 at 4.5% interest amortized over those same 30 years would be $760.50/month. Not nearly as enthused now, he nevertheless pays $761/month. He's paying an extra $87/month with the higher interest and not paying the loan down any faster.
Visualize the Numbers
If you, like me, need some tables to help organize your thoughts, here's a summary:
| Interest Rate |
Monthly Payment |
Total After 7 Years |
Total After 30 Years |
|---|---|---|---|
| 3.5% | $674 | $56,616 | $242,640 |
| 4.5% | $761 | $63,924 | $273,960 |
It's Not Really the $87 That Matters
That's not even a car payment. It's just a few meals eating out. Maybe you don't think it's a big idea. But multiply it out over the 84 months before he theoretically sells the house and it's $7,308. If he should decide to keep the house the whole 30 years, he's paying $31,320 extra just in interest.
Looking to the Future
What do you think he could have done with an extra $87/month? If he had invested it at 4.5% instead of paying the bank that extra money, he would have $8,603 in his account after 7 years. And if he kept doing it for the full 30 years of the loan he would have $66,314. And let me tell you, you can find plenty of investments that pay 4.5%.
Wrapping It Up
So to recap, that extra 1% in interest will cost our buyer an extra $87/month and an extra $31,000 over the life of the loan. If he had stopped to run the numbers, he could have not only saved himself the extra $31,000 in interest to the bank, he could have earned an extra $66,000 in an investment. That's a great start for retirement.
Tools To Use
Want to try calculating the principal and interest payments for a given loan? Try this calculator from BankRate. And when you calculate the principal and interest, don't forget that this calculator just shows the principal and interest. You still have to divide your annual house insurance and taxes by 12 and add that to the total to get an idea of what a payment would be.
You can calculate how much you can save with a given return by using this calculator from Dave Ramsey. I used a starting balance of $0, a 4.5% return and $87/month for my example here.
