The Bad News About Cheap Money

Low-Mortgage-Rates-and-Real-Estate-Bidding-Wars 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.

  1. While there is much media fooferaw about how the “housing bubble” is being driven by irresponsible first-time home owners lured by low rates, more careful analysis shows that much of the housing activity is
    is actually boomers downsizing their housing and/or moving into condos.
    These are not high risk mortgages.

  2. It makes good sense to have higher GDS during periods of low interest rates — this isn’t necessarily a bad thing. Are there some over-leveraged people getting into the market? No doubt; but most media coverage implies (with no analysis whatsoever) that this is the norm. There is no evidence that it is the norm. In fact, the opposite seems to be true.
    In a previous post, it was pointed out that:
    1) only 1/3 of mortgage activity is new mortgages — most are refinanced. This is good. It is people taking advantage of lower interest rates. And what are Canadians doing with that money?
    2) 41% of refinance proceeds were used to pay down debt. 29% was used for home renovations. 15% was used for investing. This is good.
    3) 40% of American home purchases were being made for investment purposes. In Canada: 5% This is good.
    4)Canadian mortgage arrears are still just .40%. This is good.

  3. Many people in my social circle talk about homes being affordable now because of the low interest rates. One is even buying another property with both mortgaged!
    I am in now way a doom and gloom guy, but doesn’t something have to give? People can be very short sighted and are in a world of pain when payments go up (or base their ‘affordability’ on 2 incomes when they only have 1 when the term is up – e.g., new child)…

  4. O.H. Read “Empire of Illusion” for that answer. People think reality is whatever they recently heard on the news, etc. they can’t think to the future, or think about the past…only what politicians and the media are saying right now. In other words, people can’t use critical thinking anymore.

  5. The fact that only 1/3 of mortgages are new is fairly irrelevant. People adding to their debts to pay off cars and credit cards and kitchen renos are still adding to their debts and reducing equity — which makes them that much closer to being underwater once the bubble pops.
    Since most of the 1/3 of new buyers are taking the CMHC-backed 5% down/35-yr mortgage, that’s still a HUGE portion of the market that has near-zero equity.
    Also — a growing percentage of mortgages are variable these days (over 30% I believe), so the impacts of any type of rate hike would be felt immediately by a good chunk of the market.
    Imagine if prices dropped a conservative 10%, and rates rose a conservative 2%:
    * That 5% down is now -5% equity
    * That 2% Variable Mortgage is now 4%, and minimum payments are 33% higher.
    But – don’t worry – it’s all downsizing seniors!!! None of the buyers are 20-something financially illiterate types who got scammed by an agent. No, really.
    Oh – and seniors have TONS of free cash, with all of those great income-producing investments out there (like 1% GICs – good luck living off of that).

  6. T.O. Resdident
    What? People are not adding to their debt if they’re paying down existing debt. They’re just swaping it out for lower interest debt. In the end they still have the same amount of debt, but now it’s a lot cheaper to service. Hopefully most of those who refinanced will take advantage of this period and keep their payments the same so they pay off that existing debt quicker.
    PS: Why do you just assume that everyone who takes advantage of low interest rates is a financial idiot.

  7. Do you have any data to demonstrate that “… most of the 1/3 of new buyers are taking the CMHC-backed 5% down/35-yr mortgage“. Frankly, I’m skeptical.
    Until I see mortgages go into arrears, I’m skeptical that the problem in Canada is equivalent to the US. Lenders have been stricter, and all the evidence demonstrates that borrowers have been more responsible.

  8. “most of the 1/3 of new buyers are taking the CMHC-backed 5% down/35-yr mortgage”
    I don’t believe that either. Lets see a cite for that data. Unsourced claims are of little value.

  9. I believe that the most recent stats showed that 57% of new buyers chose the 5%/35-year option.
    I’d have to dig through CMHC data to find this, but it may have even been posted on this blog in earlier months.

  10. “I believe that the most recent stats showed that 57% of new buyers chose the 5%/35-year option.”
    Isn’t that closer to 2/3’s ?

  11. so, > 50% isn’t “most”?
    How about this: the *majority* of new mortgages are 5%/35-year.
    Does the phrasing make this any less of a bubble?

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