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Which is more important, your interest rate or house price?

Yahoo Personal Finance· Vertigo3d via Getty Images
7 min read

When it comes to buying and owning a house, two significant variables will impact how much you spend on your mortgage: home prices and interest rates. While house prices are the more obvious factor determining how much you pay over the life of the loan, interest rates will also play a crucial role in the total cost of your mortgage.

This leads to an essential question for home buyers: Is it better to buy a less expensive house with a higher interest rate or a more expensive house with a lower interest rate?

Here’s what you need to know about the relationship between interest rates and house prices and how they affect your mortgage payments.

Dig deeper: When will mortgage rates decrease?

Deciding whether to prioritize a low home price or mortgage interest rate is more than just a simple mathematical question. That’s because there tends to be an inverse correlation between home prices and interest rates in the housing market. Specifically, home prices tend to be lower when interest rates are higher, and home prices typically go up when interest rates are low.

This relationship involves the economic principle of supply and demand. In this case, interest rates can affect the demand for homes in the housing market. Lower interest rates generally mean increased demand for houses, leading to home sellers setting higher home prices. On the other hand, higher interest rates can reduce the demand for homes, so home sellers lower their prices to entice potential buyers, and home values decline.

Learn more: When will housing prices drop?

Calculating the affordability of a home depends on three different aspects of the home sale: the down payment, monthly mortgage payment, and lifetime cost of the home loan. Here’s how interest rates versus house prices affect each of those factors.

Conventional loans require a down payment. Home buyers who want to avoid paying for private mortgage insurance (PMI) must put down at least 20%, although mortgage lenders may accept as little as 3% down on conventional loans. The average down payment in Q1 2024 was 13.6% (a median of $26,000), according to a Realtor.com study.

If you purchase a home with a lower price but a higher interest rate, your down payment can be more affordable. For example, let’s say you purchase a $220,000 home while interest rates are high. You can put down a 20% down payment, or $44,000, and get a 30-year fixed-rate mortgage with a 7.3% interest rate.

But if you waited for interest rates to fall before buying a home, the same house may now be selling for $300,000. Although 30-year mortgages may now have interest rates as low as 5.5% because you waited, you would need $60,000 to make a 20% down payment and avoid PMI.

Learn more: How much house can I afford? Use Yahoo Finance’s home affordability calculator.

Your monthly mortgage payment depends on several factors, including how much you borrow and the interest rate on your loan. For a $220,000 home purchase with a $44,000 down payment and 7.3% interest rate, your monthly payment toward the mortgage principal and interest will be approximately $1,207.

If you wait until rates fall to 5.5% and purchase the home for $300,000, you must find another $16,000 to make a 20% down payment of $60,000. If you can afford the higher down payment, your monthly mortgage payment will be approximately $1,363, which means you’ll pay about $150 more per month than if you’d purchased the home at a lower price and higher interest rate.

However, let’s assume you can’t afford the $60,000 down payment. If you buy the home at $300,000 with a $44,000 down payment, you will be on the hook for PMI until you have built up at least 20% equity in the home. If you pay 0.5% in PMI, your monthly mortgage payments will be approximately $1,560 for the first 50 months. At that point, you will have built up 20% equity and are no longer responsible for PMI. Then, your monthly payment will drop to $1,454 for the life of the loan. In this case, waiting until the rates decrease will result in a monthly payment that’s $250 to $350 higher.

Note: These monthly mortgage payments do not include homeowners insurance, property tax, or homeowner’s association (HOA) dues. To get even more accurate numbers, use Yahoo Finance’s mortgage calculator.

You may feel the pain of the down payment and monthly payments in the short term, but the lifetime costs of your loan are also an important factor in your housing affordability. This is where interest rates can make a big difference.

For example, the $220,000 home with a $44,000 down payment and a 7.3% interest rate on a 30-year mortgage will cost $258,378 in interest over the life of the loan — on top of the amount you borrow.

But waiting until rates fall to 5.5% and the home price rises to $300,000 will change your lifetime costs. If you put down $44,000 on a 30-year mortgage and must pay PMI, your lifetime loan costs are approximately $272,607, broken down into $5,333 in PMI costs and $267,274 in lifetime interest paid. In this case, you would have been better off buying the house at a lower price even though the interest rate was higher, saving over $14,000 over three decades.

But what if you can afford the 20% down payment of $60,000 and avoid PMI? On that 30-year home loan with a 5.5% interest rate, your lifetime interest paid is only $250,570, and you don’t have to account for money going toward mortgage insurance. You will save nearly $8,000 in interest over the life of the loan, or $13,333 if you count the money you save on PMI.

Dig deeper: Why are home prices so high?

Interest rates, home price, down payment, PMI — all individual factors that add up to the total cost of owning your home. So, the question is: What will your total home price be?

Let’s look at the three examples we’ve been discussing:

  • $220,000 house with a 7.3% rate and 20% down payment ($44,000)

  • $300,000 house with a 5.5% rate and 20% down payment ($60,000)

  • $300,000 house with a 5.5% rate and 14.7% down payment ($44,000)

In this case, buying the less expensive home with the higher interest rate saves you money on your down payment, PMI, monthly mortgage payments, and total cost. But keep in mind that the numbers will depend on your exact interest rate and house price. The lower house price won’t always beat the lower rate, especially if you don’t have a 20% down payment in either scenario.

Learn more: Believe it or not, you can get a mortgage with 1% down

This may seem obvious, but the best option is to buy a less expensive house at the lowest mortgage rate you can find. But interest rates are mostly outside of your control. Yes, a strong financial profile can snag you a lower rate, but overall, market rates are out of your hands. However, the price of the house you buy is entirely within your control. Choosing a home with a lower listing price can help you afford a higher down payment (and avoid PMI) and build equity more quickly. While better interest can lower your total home costs over time, you can also lower your home costs by choosing an affordable home no matter where interest rates stand at the time.

Potential home buyers who can afford a down payment, closing costs, and monthly mortgage payments can certainly move forward with a home purchase even if rates are high. If you do not have a compelling reason to buy a home right away, you may choose to wait in case rates (or prices) go down. But it’s tough to time the real estate market, so stay in the loop by reading professional housing reports and mortgage rate forecasts.

Refinancing can be a great way to lower your interest rates if you purchased the home while rates were high. When you refinance your mortgage, you replace the current mortgage loan with a new one. If you bought a home with a high mortgage rate, refinancing allows you to take advantage of lower interest rates when they come down. Just know that you must pay closing costs again when you refinance.

This article was edited by Laura Grace Tarpley.