Variables and First-Time Homebuyers

First-time-Home-Buyers-Mortgage Here’s an article about first-time homebuyers that shows the risks some people take with their mortgage:  See Story Here

The story portrays a young couple getting their first mortgage. It talks about how cash-strapped they are, and the difficulties they’ve experienced in affording a new home.

The story then goes on to say:  “What really helped? The 2.75% interest rate they were offered. It ultimately allowed them to move from a $1,800-a-month apartment into their own home.”

The couple then warns: “But we don’t have a lot of [wiggle] room.  We can go up to 4%, but then we’re done.”

So, illogically enough, they chose a variable-rate mortgage.

The person who recommended a variable to these folks should be examined.  A variable–rate mortgage is the last option a risk-susceptible homeowner should be considering.  Prime rate can move 1.25% before you know it.

In Canada’s current cycle, the Bank of Canada has slashed rates 4.25% in 17 months. The BoC says they will go no lower. After moving sideways, rates will start rising.  Most analysts expect prime rate to jump at least 1/2 of the amount it fell (i.e.,  at least 2+%).  The main question is when…and no one knows.

Going back to 1991, Canada has seen the following increases to prime:

  • 0.75% (In 1 month – Feb 92 to Mar 92)
  • 3.50% (In 2 months – Sep 92 to Nov 92)
  • 2.50% (In 4 months – Feb 94 to Jun 94)
  • 2.75% (In 4 months – Nov 94 to Mar 95)
  • 2.50% (In 12 months – Sep 97 to Sep 98)
  • 1.25% (In 7 months – Oct 99 to May 00)
  • 1.25% (In 13 months – Mar 02 to Apr 03)
  • 2.50% (In 39 months – Apr 04 to Jul 07)

The above list includes rate increases over both the short and long term.  A few of the short-term hikes took place inside of longer-term rate-increase cycles, so their effect would have been cumulative (i.e.  they would have added to previous rate increases).

It is worth noting that prime rate has usually fallen within 2-3 years after rising. On the other hand, Canada’s key lending rate has never before been cut to 0.25% in emergency fashion, as we’ve recently witnessed.  Perhaps rates will therefore remain elevated for longer, once they start going back up.

Whatever the case, if you eyeball the data it’s clear that a 2% prime-rate increase is very realistic in a 1-2-year timeframe.  This graph of prime rate since 1991 illustrates that.

Prime-RateThis isn’t intended to suggest where rates are going, of course. Past data is too limited and random to draw conclusions.  The point is simply that prime rate can move a lot in 1-2 years. Variable-rate mortgages are therefore unsuitable for folks with little financial breathing room.

A 2% increase in prime would raise payments 31% on a 35-year 2.75% variable mortgage.  On a $400,000 loan amount, that’s $463 more a month. 

If you’re a homeowner on a tight budget, and a 31% payment increase concerns you, don’t be seduced by today’s 2.75% adjustable rates. Look at a fixed-rate mortgage instead, or keep renting and build a financial buffer.

______________________________________________________

Sidebar: With mortgages, there are exceptions to every rule because suitability is dependent on individual circumstances. Always consult a licensed mortgage professional to see what terms make the most sense for your personal situation.

(Prime rate data courtesy of the Bank of Canada)

  1. quote from article:
    “What doesn’t help first-time home buyers? Pushy lenders, Morettie and Wilson said. Some brokers were able to find up to $850,000 to lend them. That’s an amount, Morettie said, that would have left them with about $100 in their pockets at the end of the month”
    Are these products still out there?

  2. What’s even more amazing are the multiple quotes saying no one needs to think about where they’ll be 5 or 10 years in the future…
    If fixed rates fall again this might not end badly, but at this point seems like it would already be difficult to lock in at 4% or less even before rates go up.

  3. Hi Mike, Thanks for the note. It’s tough to say what they were offered. The article doesn’t provide details. Perhaps they are self-employed and someone was inflating their stated incomes. Or perhaps the mortgage rep was quoting within the 44% maximum allowable debt ratio, but this was still too much for them to afford. Who knows….

  4. Re Variables and First-Time Homebuyers
    Since no one can predict rates perhaps the prudent go fixed with a short amortization.

  5. We were first-time buyers and went with a variable mortgage on a fairly high LTV ratio, but we were comfortable, given our situation, in our ability to carry higher payments when rates rise. It was a nice surprise for things to go the other way, however (we started at 4.15% almost a year ago and are now at 1.65%, a savings of $360/month in our case). One thing that’s helped is our decision to pretend that we’re still at 4.15% and to bank that $360 each month in a “house fund”, to use in part for lump sum payments or as a cushion should rates really climb.
    I haven’t been tempted to lock in yet and am still comfortable with the rate floating, but it will be harder to resist should fixed rates drop to the sub-4% range again, as some have speculated they might.

  6. Surely there would be certain variable products that may be appropriate for these borrowers, such as those with fixed payments? Especially when the alternative is either no house at all or a tiny condo that they wouldn’t be happy with?
    I suppose there is always a danger of negative amortization if interest rates got outrageous, but at least they would be protected to some degree. And they get to enjoy the certainty of lower payments today, which counts for a lot at the front end of your mortgage.
    This is a situation where longer amortization periods would be a great boon to homebuyers. These people seem intelligent enough – if they’re fully knowledgable in accepting that they’ll be paying a whole lot more interest than they would under a traditional 25 year am, that seems fine to me.
    Other views to the contrary are welcome…
    Al R

  7. Hi Al,
    Thanks very much for the post.
    Fixed-payment variable-rate mortgages are definitely available. The problem is that they don’t eliminate all the risk. That’s because they have “trigger rates.” If rates were to rise by roughly 1.75%, for example, the trigger rate could be hit and cause the lender to increase the “fixed” payment.
    Fixed-payment variables also usually have higher rates for whatever reason.
    Obviously, even if a homeowner’s payment were fixed, they’d end up paying less principle each month as rates rise. That’s not a good thing, especially for budget-conscious first-time homebuyers who need to build equity.
    The main things to consider, however, are the total cost and risk over five years. Prime rate will rise. People can count on it. It’s just a question of when and how much.
    When recommending a variable over a fixed rate, you have to be darn sure the borrower is comfortable with the worst case scenarios. An amortization simulation can easily show what would happen if rates rose. It many cases, depending on the assumptions, borrowers can end up paying much more over five years by being in a variable.
    Again, there are exceptions to the rules, and you have to talk to a professional for specific advice. But, by and large, we’re of the opinion that variables don’t make sense in this market for first-time homeowners.
    Have an excellent weekend,
    -rob

  8. So question then being a first-time home buyer!
    If I were leaning towards variable and am able to put 20% down would signing up for a 35 year mortgage but making payments equivalent to a 25 year one help alleviate some of this concern of where rates are headed moving forward?
    Couldn’t I adjust my payments and scale back on the additional payments if due to interest rate hikes things got tight?

  9. Thanks Rob – I wasn’t aware there were trigger payments on fixed payment VRMs. You learn something new every day! That would certainly make things unpleasant for those borrowers if prime rises significantly over the remainder of their term. Tough to have a young family in Vancouver!
    All the more reason, IMHO, that 40 yr ams are a necessary product in the market. People can argue until they’re blue in the face about whether people *should* buy a house if it requires them to pay it off over ~40 years, but I think it should be a legitimate option for certain borrowers.
    Al R

  10. TT if you are going to do that then you are probably more insulated from rate increases.
    You are not the typical first time homebuyer though. Most 1st-timers are coming into the market with 5%-10% down.
    Paul

  11. First time home buyers especially need to treat the home they live in not as an investment but as an expense: every month you will sink new after tax money into your primary residence. The bigger the residence, the more it costs (and I’m not talking just about the mortgage.)
    This market is pretty good for first time home buyers, but they shouldn’t over-leverage. As Rob says, to take on a variable, you have to be comfortable with what happens in a worse case scenario.

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