What Rates Could Do to Affordability

Affordability-and-RatesWhen it comes to home values, mortgage payment affordability acts like a giant lever.

A meaningful rise in mortgage payments (relative to income), would bear down on home prices, and vice versa.

Given this relationship and today’s towering home values, mortgage affordability is centre stage. That has inspired a stream of articles about whether swarms of people will default when rates “normalize.”

But how worrisome is that threat really? For insights, we turned to BMO Capital Markets Senior Economist Sal Guatieri.

To preface everything, here are some data points to consider…

…On Affordability

  • According to BMO, home ownership is “affordable” (for the median buyer) when mortgage carrying costs—monthly payments, property taxes, heat, etc.—don’t exceed 39% of family income.
  • Nationwide, we’re at about 31.6% today.1

…On Mortgage Payments

  • If we look specifically at mortgage payments, BMO says the average-priced house currently consumes 28% of median household income, based on non-discounted mortgage rates.2
  • That puts us right at the long-term average (see chart below)
  • This 28% falls to 23% for people living outside Vancouver and Toronto.
  • Compare these numbers to the peaks of 44% in 1989 and 36% in 2007.

 

Mortgage-Payment-Affordability

(Click chart to enlarge)

What if rates normalize?

The first step is to define “normal.” We can be reasonably confident that the new normal is less than the old normal. Reasons for that include the long-term downtrend in our domestic growth rate (see chart) and proactive inflation control by the Bank of Canada.

GDP-Growth

To pump life into the economy, the BoC has kept Canada’s overnight rate at just 1.00% for 902 straight days. According to Guatieri, “A normalized overnight rate would be closer to 3.50% given the inflation target of about 2.00%.”

Sal-GuatieriThis implies that short-term rates should theoretically jump by about 2.5 percentage points…someday. In turn, long-term rates (such as 5-year fixed rates) should rise less, maybe 200 basis points says Guatieri. That would push 5-year fixed mortgages somewhere near 4.99%.

Other things equal, these new “normalized” rates would drive up mortgage carrying costs (assuming 10% down) from 31.6% of gross income today to 37.2%. That would still fall below BMO’s threshold of unaffordability, which is 39%. But keep in mind, these affordability metrics don’t include other personal debt like car payments and credit cards.

How will borrowers be affected? 

RBC Economics writes, “Residential property values are elevated in Canada and, for many households, ownership remains accessible only because of rock-bottom mortgage rates.”

(Higher incomes have also helped affordability, notes BMO.)

But escalating interest rates aren’t necessarily a death knell. Reason being, “the eventual rise in rates will take place at a time when the Canadian economy is on a stronger footing, thereby generating solid household income gains,” says RBC. That, in turn, “would provide some offset to any negative effects from rising rates.”

The key word there is “some.” Guatieri estimates that, “To fully (our emphasis) offset a two percentage point increase in rates, household income would need to rise 19%, which could take six years if average income grows at the 3% average pace of the past decade.”

Incidentally, for major affordability damage to be done, we’d need something equivalent to a rate shock and/or serious unemployment. A rate shock is a fairly rapid increase in mortgage rates of “more than two percentage points,” Guatieri explains.

How far off is the threat?

affordability-radarIt’s difficult to estimate the probability of a rate shock, Guatieri acknowledges. “The debt market is even pricing in a small probability of a BoC rate cut later this year.”

RBC notes, “We expect the Bank of Canada to leave its overnight rate unchanged at 1% throughout 2013 and raise it only gradually starting in early 2014—a scenario posing little in the way of imminent threat.”

Take that rate forecast for what it’s worth, but regardless, “affordability is not a major problem and should not become one even when rates normalize,” Guatieri writes in this report.

That’s true even in three of the fastest growing provinces—Newfoundland, Alberta and Saskatchewan.

The affordability exceptions, not surprisingly, are detached homes in Vancouver, Toronto and Victoria. Not coincidentally, these three markets are among the most prone to the one thing that helps affordability the most: a material price correction.


Footnotes:

1 Based on a 2.99% 5-year fixed rate, property taxes equalling 1% of home value, $150 per month for heating cost, a 25-year amortization, plus fourth-quarter 2012 data provided by BMO, including: Q4 household income estimated at $75,300, an average seasonally adjusted home price of $361,523 and a down payment equalling half of personal income (i.e., $37,600 or ~10%).

2 Same assumptions as above, save for the mortgage rate. BMO uses an interest rate of 4.1% for its analysis. This higher rate makes comparisons easier over the long-run, since discounts were smaller in the past and since discounted rate data from the 1980’s is scarce.


Rob McLister, CMT

  1. That’s all fine and dandy when you have a 25 year mortgage term.
    But what happens when you have to refinance in 5 years at higher rates?
    Absolute worst decision to buy a home right now. Sal worried about those bank profits?

  2. You mean renew at higher rates? The smart money is paying off the principal today since 48% of your 1st payment at 2.99% 25yr amort goes to principal. That # goes up. 50/50 split after 5 years. HOWEVER that’s not guaranteeing you lower payments in 5 years. So pre-paying now is key, which is what I tell everyone and try to beat it into their system and way of thinking. Every bit helps.

  3. Q4 household income estimated at $75,300
    This household income is for economic families. Lots of unattached individuals are also buying, so it’s not quite accurate to leave them out of the income stats.
    As for the affordability average, it really only makes sense to look at it locally. The Canadian average doesn’t tell you much about what proportion of canadian home owners may be in trouble.

  4. I don’t see economic family income as a problem. Unattached individuals buy at lower prices than average and they meet the same debt ratios and requirements as two-person families.
    As for national affordability, it provides very useful information to lenders and insurers who lend nationally. Taxpayers and shareholders aren’t just worried about local default rates. They want to know the bank’s or insurer’s total national exposure.

  5. Perhaps a system more like the U.S? A fixed rate mortgage is fixed for the entire amortization. 30 year fixed rates in the US are running about 3.5% for well qualified buyers.
    No need to second guess the market.

  6. I don’t see economic family income as a problem. Unattached individuals buy at lower prices than average
    And economic families buy at higher prices than average.
    As for national affordability, it provides very useful information to lenders and insurers who lend nationally.
    No it doesn’t. The fact that affordability in the nation as a whole is ok doesn’t help a lender that is concentrated in higher priced markets.
    Taxpayers and shareholders aren’t just worried about local default rates. They want to know the bank’s or insurer’s total national exposure.
    And the only way they can determine that exposure is to look at the loan portfolio in detail. An average tells them nothing. 10 loans at 50% GDS and 10 loans at 10% GDS average out to a benign 30% but doesn’t tell you anything about risk.

  7. For God’s sake man, speak in specifics.
    Define higher rates.
    Tell us how many people are at risk.
    Without that, everything you wrote is just noise.
    Don’t live in fear when you can’t assess the risk.

  8. You’re way off base here. The large banks and insurers are not concentrated in high priced markets. They are geographically diversified.
    Your 10%/50% GDS example is also flawed. GDS ratios are not a double distribution as you suggest. They are a normal distribution clustered closer to the mean.
    The mean of a large normal distribution is revealing when compared historically. A 38% average GDS is dramatically different than a 28% average GDS when qualification criteria are held constant over time. If you truly think that difference is meaningless then I’m wasting my breath here.

  9. so the 10 year piece of mind from scotia is looking like a good idea along with the extra amounts to principal the renewal won’t hurt as much because it will be a lot smaller if rates normalize in 10 years

  10. My concern here is the large number of Canadians (my own clients included) who have those low below prime mortgage coming due this year (the prime minus .90). While we did qualify them at a higher rate, a lot of people have become accustomed to the lifestyle the low payments have allowed them (let’s face it, a lot of people did not pay extra on their principal or keep the higher payments). Higher car payments and lots of vacations were enjoyed, that may not be feasible when they renew to the rates now in effect…even though they are still low.

  11. The large banks and insurers are not concentrated in high priced markets. They are geographically diversified.
    For someone called statguy you are remarkably disinterested in more detailed data. I’m not about to trust that every national lender has a nice normal distribution around the national averages.
    Your 10%/50% GDS example is also flawed. GDS ratios are not a double distribution as you suggest.
    I’m not suggesting it is. It’s an example to illustrate the point that the mean in a nation with such incredibly diverse real estate markets is not a good indicator of risk.
    A 38% average GDS is dramatically different than a 28% average GDS when qualification criteria are held constant over time.
    That’s one key part, yes.

  12. There will be blood when rates go up and people will lose their homes. But it will be a dribble, not a gushing artery.

  13. The biggest issue I have is with this comment which is ALWAYS the same:
    “the eventual rise in rates will take place at a time when the Canadian economy is on a stronger footing, thereby generating solid household income gains”
    This is an assumption that may be completely false. If it is then we are in big trouble – can anybody refute that? How can one estimate 3% pay increase per year for 6 years when all around there are pay freezes and austerity etc. In addition, what exactly is “a stronger footing” for the Canadian economy? We may never see the growth of old and yet rates may have to go up anyway. I have never seen anybody address this scenario which I think is more likely than ever before.

  14. Even the experts an speculate on when rates will rise again but no one really knows. Until the Feds start to raise their rates, Canada will just steady the course. The fundamentals are not in place for inflation to rise. The really low variable rates are gone but good variable rates could be available for some time yet. The smart borrower pays extra each month in anticipation of a rise at some point.

  15. Excellent question that is complex to answer beyond saying, Canada’s banking model, like our politics, health care, education or tax system is not the same as the U.S.
    But to try to answer your question, our bank funding model that the respective federal or provincial governments regulate and guarantee, is built around maximum 5 year term GIC’s or bonds which would suggest, Canada has always had the expectation that the borrower and not the bank, should take on more interest rate risk than the U.S. model.

  16. If 5 years from now, the rates goes to 5%, most homeowners will refinance it for Another 25 years. Payments will actually go down based on the new balance of the mortage (approx 285k ). the new Mortgage pmt will actually be lower to about 1350$.mo…or at an affordability ratio of 22% or less.

  17. Your math is off pal. The payment would be higher, even if you re-amortize to 25 years, and even if your balance is less after 5 years of payments.
    Furthermore, you can’t reset your amortization unless you have 20% equity.

  18. I agree this article is a lot of noise with no specifics. The fact is rates are amazingly low and the smart consumer will concentrate on lowering his principal. I paid 19.9% in 1980 and that was traumatic even if the mortgage balance was lower than what we see today. We hunkered down and adjusted.
    Just my 5 cent!!

  19. I wouldn’t be paying off the principal.
    Instead, save the money and buy tax efficient dividend paying stocks. I can get 6.6% out of COS, 4.7% out of BMO and there may even be a dividend increase or two. Yes, the portfolio may go down, but I bet these stocks will be worth more 10 years from now.
    Why not use the bank’s money?

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