Monday, September 7, 2009

Interest Rates 3: the impact of rising rates

On Saturday we talked about rising interest rates.

The posted 5-year bank mortgage rate has NEVER been below 5% going back over 60 years. Never... until now.

The housing bubble that has developed the past 9 years has been driven by artificially suppressed interest rates, a course of action which has intensified since the market collapse in 2008.

You can currently get a 5 year fixed mortgage rate of 3.79%, a lure which is triggering record real estate sales while we languish in record unemployment and the worst recession in 80 years.

Canadians are being sold an image that real estate has entered an age of 'affordability', but how long will that age last?

A $580,000 home with a $30,000 down payment (which is 5% down) results in a $550,000 mortgage. At 3.7% the monthly payment (including property taxes) is going to be $2,910.21.

If rates go up a measly 2%, the monthly payment jumps to $3,598.95, almost $700 per month more.

If rates return to the historic norm of 8%, our $550,000 mortgage will require a monthly payment of $4,479.35, almost $1,700 per month more than today.

The result?

The Lower Mainland will almost certainly be hit with a tsunami of defaults and foreclosures. Having already purchased the maximum they could afford at these historic low rates, who will be able to afford a jump of $1,700 (or more) in their monthly payments?

But that is only one aspect of the catastrophe that will ensue.

Consider the plight of the potential home buyer, the one who might purchased our fictitious $580,000 home with 5% down in the era of increased interest rates.

In today's market he qualifies for that $550,000 mortgage loan only because he can (barely) make the $2,910.21 monthly payment at 3.7%.

When interest rates rise, he can still only afford to qualify for a mortgage where he pays approximately $2,900 per month.

The only way he can buy that $580,000 home is if the price comes down - dramatically.

If interest rates rise to 8%, The maximum mortgage he can afford will be $365,000. Factor in his 5% down payment, and that $580,000 home must be reduced to $385,000 if it is to sell to our buyer.

That's a reduction of almost 40%!

If interest rates rise to 12%, the selling price of that home must drop from $580,000 to $274,000, a reduction of almost 50%.

And if interest rates creep back to 15% or higher - just like they did in 1980, '81 and '82 - the selling price of homes in the Lower Mainland will have to drop by 60 - 75% if they are to sell to buyers who must assume large mortgages.

When you combine all of these factors: (1) buyers from the last four years who will default and be foreclosed on as rates start to rise, (2) banks selling foreclosed properties for whatever they can get, (3) potential buyers who will only be able to secure mortgages for 40% - 50% less than the current 2009 market values, and (4) a second surge of inventory from homeowners who can still make payments at the higher rates but who will then default because plunging property values have rendered their bloated mortgages un-renewable...

And you have a potential storm that could utterly devastate the Lower Mainland real estate bubble.

It all comes down to this.

Do you believe interest rates will remain at these historically low levels for the next 35 years?

If the answer is yes, then buying in the current market is a smart move.

If the answer is no... then you can clearly see how the Lower Mainland is being set up to to suffer the mother of all housing collapses.

Which brings us to this interesting article in today's London Telegraph newspaper, Interest rates 'could rise sharply early next year' – and by more than in previous cycles.

Under these circumstances, plucking the cheese from the Lower Mainland's mortgage traps is nothing short of Mission Impossible.

Happy Labour Day!


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  1. The "posted" 5yr rates were never below 5%, but we did get below that (around 4.3-4.9%) in the last 3-5 years though.

  2. Good Morning, it occured to me that a 5 yr. mortgage implies that, depending on the percentage of 5 yr. mortgages, there will be those that are locked in and still have 5 or less years to pay up or default. Presumably the market bubble wouldn't burst the second interest rates rise, there would be a lag time of 0-5 years? How can we guesstimate what this period might be?

  3. In first quarter 2004 a 5 year rate could be had at Vancityy for 4.3%. So, they have in fact been below 5%.

  4. In addition to the errors regarding the 5 year rate, the other error concerns the 'tsunami' of foreclosed homes that are apparently on the horizon.

    why can't these home owners just fix their variable rate when the rates start to rise ?

  5. Thanks for the comments, I appreciate the feedback.