Thursday, July 30, 2009

Why Interest Rates Will Collapse Real Estate Prices

We've discussed this before, but it's worth re-iterating.

Rising interest rates will collapse real estate prices in Vancouver.

And make no mistake, interest rates are going up.

Last week the govenor of the Bank of Canada (Mark Carney) urged that "Canadians should be preparing for the day when their borrowing costs eventually return to more normal levels."

Canada's historic 'normal' is 8%. That represents more than a doubling of current rates.

Real estate prices can be set to whatever level the seller desires, however the value of a house will eventually settle to the price that buyers can actually afford.

And since very, very few people buy a house with cash, what people can afford will be determined by interest rates.

A doubling of interest rates will slash what people can afford in half.

Charles Hugh Smith ( has produced these charts to demonstate the see-saw relationship between housing prices and interest rates (click on image to enlarge).

In the graph above, a low interest rate (in this case 4.5%) will produce a monthly mortgage payment of $1,850 on a $500,000 mortgage.

But if the interest rates doubles, in this case to 9%, then...

... then a monthly payment of $1,850 will only allow a buyer to assume a $250,000 mortgage.

Which brings us back to the original issue: "The value of a house will eventually settle to the price that buyers can actually afford."

In the absence of a vibrant economy that generates more income for buyers to assume larger mortgages at higher rates, buyers are forced to reduce the size of a mortgage they can assume.

And a voracious demand for global capital is on the cusp of forcing interest rates back to historic norms (if not higher), it means a return to 'normal' interest rate levels will wipe out the market for average Vancouver homes that sell in the current bubble inflated $800,000 to $1.5 million range.

Buyers will only be able to afford mortgages at half the current amounts... a stalled economic recovery will guarantee this.

(lower, if rates spike to 11% or higher)

Canadians snapping up $600,000 plus mortgages today because they can 'finally' afford them with these historic low interest rates of 3% are making the worst financial decision of their entire lives.

Not only will 'normal' interest rates reduce other homes to half of what they paid for theirs... when these Canadians go to renew their mortgages after their 1-5 year term expires... they will be in a massive underwater position and they will default on their own mortgages.

It's an outcome that will only further depress market prices.

Their only hope lies in interest rates returning to low levels very quickly once they rise to this point.

And that's not going to happen.


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1 comment:

  1. I'm curious to see how this all plays out. Obviously the rates need to go up, but the BOC must be terrified that any increase in rates will put the economy into a tailspin. The thing is, the rates in Canada and the US should never have been as low as they were for the past years. At some point we need to accept the hangover that followed the binge. The longer we put this offer the worse it becomes...