Mortgages
I just had the privilege of spending the past two weeks visiting family in beautiful British Columbia. B.C. has this interesting phenomenon called “Summer”. What happens is that for a few months out of the year the rain goes away and the temperature rises above 18 degrees Celsius. It’s quite an interesting phenomenon and I hope you all experience it once in your lifetime.
While in B.C., I had a conversation with my father-in-law about mortgages. I told him that one thing that irritates me is when I hear people say that right now is a great time to buy because interest rates are so low. This is a shortsighted view that doesn’t take into account the fact that interest rates are artificially low.
One major element of the sub-prime interest rates debacle is that people were offered mortgages that had artificially low interest rates in order to entice them to buy. They were excited that they could finally get a mortgage and at a great rate. Unfortunately, shortly afterwards more realistic rates kicked in and homeowners realized they couldn’t afford the true payments on their houses and they defaulted.
Today’s situation is not completely the same, but there is one striking similarity. As with the sub-prime scandal, current interest rates are unrealistically low. According to Canada Mortgage and Housing Corporation (CMHC) data, May 2009’s 4.62% 5-year fixed mortgage rate is the lowest our country has seen in at least 58 years. The closest rate was 5% in March 1951. Thus, we shouldn’t look at current interest rates as a blessing because they are rare, unrealistic and unreliable. It would not be in a homeowner’s best interest to base decisions on this rate.
We need to ask ourselves, “What will happen when historically accurate interest rates return?” The median interest rate this millennium has been 6.24%, the median in the 90s was 8.67%, and in the 80s it was 12.65%. These rates represent a more accurate picture of what interest rates will be throughout the life of your mortgage. Can you afford these rates? Will you be a sub-prime victim and realize in 5 years you can’t afford your mortgage payments?
To put these interest rates into a different perspective I computed the weekly mortgage payments for these 4 interest rates. I used weekly payments because it will decrease your interest charges. I also assumed a 5-year fixed term on a 25-year mortgage. Lastly, homes sold for an average $245,000 in the Halifax CMA, so I assumed a 5% downpayment; translating into a mortgage amount of $232,750 (See Table 1) .
Would you be able to afford mortgage payment increases of $200.92 or $526.08 per month? I’d imagine that a lot of homebuyers hope that an increase in mortgage payments 5 years from now will correspond with an increase in salary. But, we would then have to factor in income taxes. And, one would have to be born yesterday to believe that a salary increase doesn’t result in an increase in consumer spending (i.e. clothes, cars, entertainment, etc.). Therefore, in order to drive my point deeper, I’ve assumed a 35% income tax rate on the salary increase and that only 50% of the pay increase goes towards the increased mortgage payment (See Table 2)
In your profession, will you be able to achieve a $7,418.58 salary increase in 5 years? $19,424,49?
I’m not into fear mongering and I don’t want this article to come across that way (the sub-prime reference was borderline, I admit that). All I want to highlight is that interest rates are artificially low, and as such should not be regarded as a blessing, but as an abnormality that should be treated with suspicion. If you can afford your dream house now, big deal. You have to crunch the numbers and figure out if you’ll be able to afford it at more historically accurate interest rates. If you can presently afford mortgage payments at an 8% interest rate then you’re in a good position. If you can’t and are hoping for a pay increase down the road, is that raise possible and will it be large enough? If it will be, then you’re in a good position. If it won’t be, then you need to reconsider your options.
I am not sure that I agree with the premise of this article. It is good to be prudent, but looking back on interest rates only into the eighties tends to make the picture bleaker than it may actually be. The spike in interest rates in the latter part of the last century was an enormous anomaly, in a broader historical context. Will it be repeated? I’m no economist, but I don’t think the world economy can handle a drain of that magnitude again for a long, long time. Rates are super low now because too much money has been siphoned upstairs for too long. Even the plutocrats realize that you cannot get steaks and milk from the same cow indefinitely. Take a look back to the sixties, when interest rate cap legislation was gutted, to find the source of many of the economic swings we have experienced in the past forty years. Like the securities legislation put in place in the thirties (and since removed, arguably leading to the latest recession), rate cap legislation was crafted by wiser, longer-sighted men than those running the ship today. The marketplace has corrected itself, as it must, but the incidental damage has been brutal.
Thanks for your feedback Alan.
The main point I was trying to get across in this article is that when estimating how much you can afford, the current interest rates are anomalies and one shouldn’t use them to forecast for the next 5-10 years. You should see how much you can afford at a rate of 5%-7% because that seems to be about average. Maxing your mortgage payments at the historically low levels we’re seeing now is short-sighted because rates will go up. I threw the 80s example in there just to remind people that rates do go up. Plus, if you unpack that 12.65% a little bit and realize that’s only the median, then there must have been some rates above that. But yes, the 80s was an anomaly.
I take issue with rate caps being wise. I don’t think one can mess with the free market and expect no repercussions. Rate caps are only worthwhile when the lenders want to charge a high amount. Let me use an example: The cap is 9%, but everything else is yielding 11%. So lenders are only able to charge 9% on mortgages, but they see other instruments are returning 11%. They would take their money out of mortgages and put them in the other instruments. That would dry up the money left for mortgages. With less people able to buy, house prices would go down. This isn’t a good thing either.
I’m a believer in the invisible hand of the market. A lot of people are understandably scared of the free market because of the events over the past few years. But the free market didn’t necessarily screw things up. The bankers and financiers screwed it up. They are the ones that convinced people sub-prime mortgages are OK, that credit default swaps are fool proof, that collateralized debt obligation tranches should all be rated AAA, that financial equations will defy the law of economics. I equate the free market to a motor vehicle and the bankers to a speeding driver. If the driver crashes and hurts someone you don’t blame the vehicle and through it in the landfill; you charge the driver. But at the same time, someone going 50km in a 100km zone isn’t the solution either because they are impeding the flow of traffic (I equate this slow driver to over regulation).
I agree, the incidental damage has been brutal over the past few years and its a shame that more people haven’t been charged. I hope we can all learn from this and be better off for it.
Take care.
Travis Bartel