The Bad News About Cheap Money

The media has been wallpapered with stories about how low mortgage rates are inflating real estate prices.  Here’s an interesting one from the Globe, full of disconcerting statistics: Easy credit, soaring prices…

The gist of it:

• Home prices have risen in 20 of the 25 largest cities this year, and in all 10 provinces.
• Mortgage credit was 74% of personal disposable income in 2004. Today it's 96%.
• Canada’s debt-to-income ratio is now a chilling 140%, up from 131% last year. The formerly spend-happy Americans peaked at 127% at the height of their bubble.
• Mortgage growth was “virtually non-existent” in past recessions says the Globe. This year, it’s up 7%, adjusted for inflation.
• We’re bucking significant odds because housing prices don't typically survive recessions. In 1989, for example, the market collapsed 28%, and didn’t bottom out for five years.  It didn’t fully recover until nine years later.

“Interest rates are very low, and that is no doubt contributing to some additional activity in the real estate market,” said Finance Minister, Jim Flaherty, on Thursday. “We'll watch, and what we've done before, we can do again if we need to.” (i.e.,  The Finance Department can tighten mortgage rules, like it did when eliminating 40-year amortizations.)

Whether that’s advisable is another debate.  In the meantime, however, people must think a few steps ahead because today’s abnormally low rates won’t last.

CIBC economist, Benjamin Tal, says: “Even if you lock in a five-year mortgage rate, you have to realize that five years from now, they will be significantly higher...”

Mortgage professionals have an obligation to warn clients that rates could be much different at renewal.  At a minimum, it’s not unreasonable to plan for a 2.5% rate increase.

Supposing that happens (i.e., rates are 2.5% higher at renewal), and supposing you have a $300,000 35-year mortgage at 4% today:

• Your payments would jump $473 a month (36%)
• You’d need $74,000 of income to qualify for the mortgage, versus $62,000 today. (3.6% annual wage growth)

That’s based on the traditional 32% gross debt service (GDS) guideline. Mind you, someone with a 680+ credit score and minimal debt would qualify for more house, based on the total debt service (TDS) ratio, in lieu of the GDS ratio.

That said, there might be a fair number of people who merely sign their renewal offers in five years (and take the above-market rates their lender sticks them with), because they can’t qualify to transfer their mortgage elsewhere.

If lenders ever decided to make people re-qualify at renewal, a certain number of homeowners could be up a creek. But lenders say the odds of requiring re-application are low.