TD Sees 10% Price Drop and Says 40% Now in Variable Mortgages

falling-home-valuesAverage Canadian home prices will slide about 10% within two years, projects TD Economics.

TD says, “Toronto and Vancouver appear most at risk” and will disproportionately weigh down the national average.

The reasoning is all spelled out in this report. TD lists several potential home price killers, including “subdued job and household income growth, rising interest rates, the recent tightening in borrowing rules for insured mortgages, and fewer first time home buyers.”

The report also has a slew of mortgage-related findings. Here’s a sampling of those (italics ours):

  • 40% of current mortgage holders are now in a variable-rate mortgage, up from 24% in 2007.That’s clearly a notable shift. It’s occurring in part because people are becoming better educated about the mathematics supporting variables. If you’re considering a variable, confirm that you can comfortably handle payments at a 3% higher rate—even if you deem that increase a small probability. Currently, insured borrowers with less than 20% equity must show they can make payments at the qualifying rate (5.54% today). This is a “safety catch” that factors in a 3.39 percentage point rate increase. While that may seem conservative, debt ratio analysis based on the qualifying rate doesn’t always factor in peoples’ unreported and/or “lifestyle” expenses.
  • mortgage-interest-rate-forecastHere’s TD’s latest rate forecast for you variable mortgagors looking for a light in the dark. TD says: “We expect the tightening of monetary policy to now begin in January 2012. Gradual increases thereafter will take the overnight rate to 2.00% next year. After pausing to reassess the situation, the central bank is posed to further lift the rate to 3.00% by mid-2013.”It’s an understatement to say that this forecast is subject to change. But, if you assume these numbers are near the money, you’ll find that 5-year fixed and variable rates are neck and neck in terms of hypothetical interest cost over five years.
  • TD suggests that variable-rate payments will rise $110 per $100,000 of mortgage, based on its 200 bps rate hike projection.
  • “Interest rate hikes in conjunction with the amortization rule change will price out some buyers, particularly first-timers.”As a rough rule of thumb, for every one percentage point that rates go up, buying power for people with a mortgage (i.e., maximum mortgage amount) drops by about 9%. This applies to borrowers getting a high-ratio mortgage with an average debt level and average income.
  • About 1/3 of borrowers will be impacted by high-ratio amortizations being reduced from 35 years maximum to 30 years.
  • Regarding the prospects for drastic rate increases, TD says: “A disruption in employment in Canada due to an unanticipated global shock is probably a higher risk scenario than a spike in interest rates at this stage.”

TD’s Overnight Rate Forecast

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TD’s 5-year Bond Yield Forecast

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Rob McLister, CMT

  1. So what they are really saying translated a different way is “Toronto and Vancouver markets are ludicrous, and may return to ridiculous or even all the way down to preposterous over the next two years.”

  2. As rates rise, I wonder how many VRM holders will actually switch to fixed at the right time versus freeze like deer in the headlights until they’ve missed the opportunity to get out.
    Back in 2007 or so my relatives (and many others) in Poland took out mortgages in Swiss Francs to take advantage of the interest rate differential. Since then, the Polish Zloty has collapsed vs the Franc resulting in a huge payment shock. My relatives could have switched back to a Zloty loan at any time, but they didn’t because they were waiting for the exchange rate to improve… Good luck with that plan.
    Thus, VRMs strike me as a large additional risk to the Canadian housing market. In theory everyone could switch to fixed while it is to their advantage. But how many actually will? Those that don’t may get caught in an interest rate surge that will wipe them out.

  3. I don’t think TD should speculate with their own business, because if the market is difficult and risky nobody will want to buy houses and then TD (and all others) won’t make money.
    People should be more concern of maintaining the low interest until recovery is consolidated. Come on….they are making tons of money right now and they want more??? let the people prosper and grow. At the end we all win.

  4. In my mortgage practise I find some clients choose a VRM because the current mortgage payments are lower than on a five-year fixed rate. Let’s help clients look at the long-term pros and cons of a VRM, especially if they don’t have alot of equity in their homes. The average rate between a five-year fixed rate and a five-year VRM will be be very similar over the next five years.

  5. Hey Rob,
    Here is a quote from Dec. 2009
    C.D. Howe president and CEO William Robson says a rapid rise in interest rates expected late next year could prove devastating for homeowners who have not evaluated their ability to carry their mortgage at a higher interest rate.
    Did this happen? (the rapid rate increase?!)
    cheers,
    Brian

  6. Hi Brian,
    Thanks for the post (and rhetorical question). :)
    It’s certainly one of many reminders of the fallibility of rate expectations.
    On the other hand, I haven’t seen the context so I’m not sure if Robson was actually making a rate prediction, or just warning people to prepare “in case.” It’s always tough to look back and judge people for their expectations then, based on the benefit of our knowledge today.
    The key word in that quote is “expected.” None of us really know where rates will be in 1-2 years. It’s certainly prudent to prepare for the unexpected. That’s why standard procedure in mortgage planning is to “evaluate” one’s ability to comfortably carry a home if rates significantly exceed forecasts—no matter how small we personally feel that probability may be.
    Have a good weekend!
    rm

  7. Most lenders will allow consumers to covert from adjustable to fixed at no charge. But the problem with the major banks is that they guarantee nothing in writing on conversion. Lenders such as ING and MCAP will provide the borrower with their lowest discounted rate on conversion. So even if both adjustable and fixed rates increase in the future, the homeowner can at least rest easy knowing that they will receive the lender’s lowest rate when they convert. The banks, however, guarantee nothing. So if you have an ARM and you want to convert to fixed, you are virtually guaranteed not to get the lowest rate upon conversion. This is further proof that rates mean nothing and the fine print means everything.

  8. Hi Sandra,
    Thanks for the post. It would be interesting to explore your point about equity in relation to variable mortgages…if you’d like to share more thoughts on that.
    Your assessment of average rates over the next five years certainly mirrors market sentiment. Eventually the market will be right (it hasn’t been for 2 years) and fixed may outperform variable in one or more 5-year spans.
    For most typical borrowers, however, that might be irrelevant for practical purposes. That’s because it may require perfect timing to benefit from a 5-year fixed, and we all know how hard it is to time the market.
    Thankfully, most homeowners can take solace that there is no evidence to dispute that variable will remain the better value over the long-term.
    Cheers…

  9. Hi WJK,
    Ouch. Currency risk certainly adds a whole other dimension to mortgage planning.
    It also works in reverse, as many Canadians have pleasantly found when mortgaging U.S. properties over the last decade.
    In general, homeowners are notoriously bad at timing mortgage rate conversions—just like they’re bad at timing the stock market.
    Regarding rate risk, it’s reasonable to assume abnormal default levels if rates exceed expectations. Fortunately, high-ratio borrowers are qualified at rates 325 basis points above today.
    It would take quite an unexpected rate increase for real damage to be done, and it would have to be sustained. That’s not impossible but most economists assign it very low odds. That’s because the growth and inflation outlook don’t support extreme rates over the long-term.
    Moreover, the “risk group” (i.e., mortgagors with <20% equity, 40%+ debt ratios, etc.) is really quite small. CIBC pegs it at roughly 4.1% of mortgages.
    Cheers...

  10. @Lior: Great points, but let’s be clear on the nomenclature: a variable rate mortgage is not an ARM. An “ARM” is an adjustable rate mortgage, and where I am in the States, it’s pretty much the same thing as a 5-year fixed mortgage (or 3-year, or 4-year) in Canada. (The standard mortgage product here in the US is a 30-year fixed loan — that’s right, the payments are fixed for the life of the mortgage. Unfortunately there’s no such thing in Canada.)
    A lot of people in the States blame ARMs for contributing to the downfall of the housing market. When those 5-year fixed mortgages reset to higher rates, Americans felt the pain… and unfortunately for Canadians, the same thing is going to happen to them.

  11. ARMs didn’t cause the downfall in the states. Bad underwriting caused the downfall. Qualifying people at a 2% teaser rate and not confirming income caused the downfall.
    Canadians have been renewing 5 year fixed mortgages for over 40 years. Let’s not make something out of nothing here.

  12. As the old saying goes, never get too greedy when it comes to deciding if you should jump from a variable to a low fixed rate….its getting time but thanx to sites like this i think too soon to jump to a fixed…

  13. We’ll see. Since the 80’s, Canadians have been fortunate to experience steadily declining interest rates. We’re at an unprecedented time in history right now with rates having nowhere to go but up.
    Canadians will undoubtedly be renewing their terms at higher rates. At what degree of pain is the only question.

  14. We have to be reminded that many folks are in Variable rate mortgages making payments as a 5 year fixed rate to avoid any interest rate shock. And that the reason Variable rates are attractive to borrowers is likely the prepayment penalties are set at 3 months straight interest. Fixed rate penalties have seen some pretty fancy IRD calculations being created, and until the Bank of Canada passes a standard calculation the number of people choosing a variable rate is not going to change. Too many people paid outrages IRD prepayment penalties from 2007-2009. (TD included)The Best advice is to always use a knowledgible experienced Broker to compare calculations.

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