Great article on the effect of rates on housing affordability…
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February 25, 2013
What Rates Could Do to Affordability
When 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…
• 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.
(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.
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%.”
This 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?
It’s hard 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.
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.
Raymond Lee | Director of Business Development
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Month: February 2013
Interest rates rising: Are you living on the edge?
By GoldenGirlFinance.com | GoldenGirlFinance.com
Canada’s benchmark interest rate has been at 1 percent for more than two years and, as a result, a lot of Canadians have gotten pretty comfortable floating along on a cloud of cheap debt. Unfortunately, most economists agree that the air will go out of that cushy lifestyle – perhaps as early as this year – when interest rates rise. The problem is, most of us are just so darned comfy, we haven’t given much thought to what a rate increase could mean to our finances and financial well-being. In other words, many of us are living in a dream…and deliberately ignoring the fact that we may be drifting toward a serious financial wake-up call.
Are you living on the edge? Find out what areas of your financial life would be affected by an interest rate increase and what it could cost you.
House and home
According the Canadian Association of Mortgage Professionals’ 2012 consumer study, about 28 percent of homeowners have a variable-rate mortgage. And let’s just be clear: Those mortgages have provided huge savings in recent years. Remember, the interest rates on variable-rate mortgages are based on the prime rate, which may vary slightly from bank to bank, but is based on the benchmark rate set by the Bank of Canada. Because the benchmark rate has been so low, borrowers have enjoyed very low interest costs on their mortgages. Unfortunately, experts say the party may soon be over, and when the BOC does boost interest rates, the payments on variable-rate mortgages will rise too.
So how would that affect you? Well, let’s suppose that you have a mortgage with a $300,000 balance at a 3 percent variable interest rate and 25-year amortization. That equates to a monthly mortgage payment of $1,419. Now, suppose that your mortgage rate increased to 3.5 percent based on an increase in the prime rate. Now, your mortgage payment would be $1,497. For most people, that kind of increase isn’t too unmanageable. To be safe, however, most experts recommend that those who choose a variable-rate mortgage be prepared to pay up to 2 percent more per month, which would boost the monthly payment on that $300,000 mortgage to $1,744. That’s $325 more per month, a number that could prove to be a serious burden for cash-strapped borrowers.
Are you living on the edge?
Some variable-rate mortgages allow borrowers to lock in at a fixed interest rate. However, this option often includes a fee, and is likely to lock you in at a higher rate than the one you would have gotten had you opted for a fixed-rate mortgage in the first place. If you opt for a variable-rate mortgage, you have to understand that it’s a bit of a gamble. If you’re on a tight budget and paying a variable rate, you’re living on the edge.
Credit and debt
According to TransUnion, lines of credit account for about 42 percent of the $25,000 of non-mortgage debt the average Canadian carries. In many respects, a line of credit is a great way to borrow money. It’s flexible, it comes without fees and it’s much cheaper than a credit card. The risk here comes with the fact that lines of credit are variable-rate loans, which means that a borrower’s minimum payment can increase significantly if interest rates rise. This can hit people especially hard if that increase is combined with other forms of variable-rate debt.
So, let’s suppose that you’re carrying $10,000 on a line of credit at a 5 percent variable interest rate. The minimum payment on most lines of credit is 3 percent of the balance, which in this case would amount to $300. Now suppose that rate rises by 1 percent. In this case, your debt will rack up about $8 more per month in interest charges. That may not sound like much, but thanks to the power of compounding, even modest interest rate increases can make a large debt grow a lot faster, making it harder to pay off.
Are you living on the edge?
Tighter lending rules and softer profits for banks have pushed many lenders to increase the borrowing rates on lines of credit. In 2012, some banks raised the rates on these loans by upwards of 3 percent. Take a look at what you owe and what a rise in rates would do to your payments and balance. If it’s more than you can afford, you’re living on the edge.
Savings and investments
It’s easy to assume that a rise in interest rates is all bad news, but that’s only if you’re borrowing. If you’re saving and investing money instead, higher interest rates can actually be a good thing. Just as the benchmark rate influences the rate at which banks lend to consumers in the form of mortgages and other loans, it also affects the rate of interest the banks pay to depositors. This means that high interest savings accounts, GICs and cash-based investments all get a boost.
For example, the current rate of return on a 5-year GIC is around 2.25 percent. In 2008, that number was more like 4 percent. In the 1990s, rates were as high as 8 percent. These rates of return were influenced by the benchmark rate at the time. So, although consumers may have been hit hard by higher borrowing rates during those times, they also got to benefit from higher returns on guaranteed investments.
Savings help protect you from changes in the interest rate by providing a cushion to help cover higher debt repayment. In addition, the returns on savings accounts and guaranteed-return investments like GICs rise along with interest rates, helping to mitigate the risk of these rises to your overall financial stability. If you don’t have a savings account or investments, you’re living on the edge.
Stepping back from the edge
Interest rate fluctuations are a fact of financial life. The ultra-low interest rates we’ve enjoyed over the past few years have made it easy to live on borrowed money, but all that really amounts to is living a dream. When interest rates rise – and eventually they will – it’ll be time to tighten our belts, step back from the edge and wake up to reality.
GoldenGirlFinance.com is a free personal finance and education site for women.
Nothing contained herein is intended to provide personalized financial, legal or tax advice. Nothing should be construed as an offer to sell, or a solicitation of an offer to buy a security, a recommendation for any product or service by Golden Girl Finance or any associated third party, or a suggestion regarding the purchase, holding or sale of securities. Before implementing any financial strategy, you should obtain information and advice from your financial, legal and/or tax advisers who are fully aware of your individual circumstances.
Most Canadians dream about buying and owning their first home. A significant rite of passage, buying a home is not only a big financial deal, it’s a big life deal.
Most people assume it’s better to buy a home than to rent, and to be honest, I have a bias toward home ownership, too. That being said, I have counselled people on the merits of renting. Recently, I met a young man named Sam, and thought I would share his story on renting versus owning.
RENT OR OWN
Every new homebuyer should first understand the differences between “renting and saving” and “buying and owning.”
For most people, renting is better on cash flow, not just because mortgage payments are often higher than rent but because of all the other costs associated with owning a home, such as condo fees, property tax and maintenance.
The idea of building equity can justify the increased strain on cash flow, but renters can build equity through renting and saving.
RENT AND SAVE
Sam is 26 years old and currently paying $600 per month in rent. He shares a three-bedroom condo with two roommates and has saved $25,000 to buy his own place. Sam has found a two-bedroom condo for $300,000 but is nervous about taking the leap.
Based on a five-per-cent interest rate, a $275,000 mortgage would require monthly payments of $1,600. Condo fees and property taxes would add $350 per month, bringing the total monthly cost to almost $2,000. That’s a big increase from $600-per-month rent.
BUY AND OWN
Let’s assume Sam buys the two-bedroom condo and we look ahead five years. In that time, Sam will have paid down his mortgage balance to $243,395, which means he has built up $31,605 of equity (assuming no growth on the property).
What will Sam’s situation look like five years from now if he continues to rent? In the rent-and-save scenario, if Sam can afford $2,000 per month to buy the home, theoretically he should be able to save $1,400 per month ($2,000 less $600 rent). If he were to save $1,400 per month for five years, he would have $84,000 in savings or an investment (also assuming no growth). This simplified mathematical analysis makes rent-and-save look like a better financial option after five years than buy-and-own.
CAN HE SAVE THE DIFFERENCE?
The biggest challenge in renting and saving is, of course, the saving part. Few of us have the discipline to save $1,400 per month for five years.
Buying and owning for some is a means to force savings, with mortgage payments seen as one of the most important payments you make.
Although Sam feels he is a pretty good saver, he does not think he can save $1,400 per month. He’s also concerned about becoming house-rich but cash-flow poor. He wants to enjoy life, and buying a house would drastically reduce extra cash flow.
One option is to get a roommate in the new condo to help pay expenses. Sam’s costs will drop to $1,400 per month. If he continues to rent and saves the difference of $800 his roommate is paying, he will have $48,000 after five years.
If we work backward to figure out how much he needs to save per month to have the same $31,605 equity in the home, he would have to put away about $525 per month.
INVESTING VERSUS REAL ESTATE PRICES
In this example, I have assumed no growth in property values or alternative investments. Sam asked me which would give him a better return, investing in real estate or mutual funds?
Real estate agents are likely to tell you that owning is a great investment because house prices are going to go up. Investment professionals will tell you that investments have performed better. The problem is no one knows which will do better in the future.
So although there are advantages to buying a house, it may not always make sense.
Jim Yih is a financial expert. Visit his award-winning blog, RetireHappyBlog.ca
How Much Does The Mortgage Rate Matter?
Often times, borrowers are fixated on their mortgage rate because it’s the one aspect of their home financing they know to ask about. But, it’s important to look beyond mere rates into the bigger picture surrounding what’s significant when it comes to your specific mortgage needs.
If we dollarize the difference between 2.99% and 3.04%, for instance, it works out to an additional $2.66 in your monthly payment per $100,000 of your mortgage. Over the course of a five-year term, this culminates into just $159.60 per $100,000.
While “no-frills” mortgage products typically offer a lower – or more discounted – interest rate (like the 2.99% used in the example above), when compared with many other available products, the lower rate is really their only perk.
The biggest problem with looking at rate alone is that you may end up paying thousands of dollars in early payout penalties if you opt for a five-year fixed-rate mortgage, for instance, and then decide to move before the five years is up.
No-frills mortgage products won’t let you take your mortgage with you if you purchase another property before your mortgage term is up – ie, portability is not an option with this product. Portability is an important option that could save you money over the long term if the home of your dreams is within your reach before your mortgage term is up and rates have risen, which they have a tendency to do over a five-year period.
This type of product is only plausible for those who have minimal plans to take advantage of benefits that will help pay off your mortgage faster – such as prepayment privileges including lump-sum payments.
Essentially, this product is only ideal for: first-time homebuyers who want fixed payments and have limited opportunities to make lump-sum payments during the first five years of their
mortgage; and property investors who need a low fixed rate and aren’t concerned with making lump-sum payments.
It’s understandable why these products may seem appealing. After all, not everyone feels they have the extra cash to put down a huge lump-sum payment. And who needs a portable mortgage if you’re not planning on moving any time soon?
But it’s important to remember that a lot can change over the course of five years – or whatever term you choose for your mortgage. You could get transferred, find a bigger house, have babies, change careers, etc. Five years is a long time to be anchored to something.
Many people won’t sign a cell phone contract for longer than three years that they can’t get out of, so why would they then sign a mortgage for five years that they can’t get out of?
The thing is, you can still obtain great mortgage savings without giving up the perks of traditional mortgages. For starters, many lenders are willing to offer significant discounts if you opt for a 30-day “quick close”.
And there are many other ways to earn your own discounts. For instance, by switching to weekly or bi-weekly mortgage payments, or by obtaining a variable-rate mortgage but increasing your payments to match those of the going five-year fixed rate, you’ll be ahead of the typical discount of a no-frills product before you know it – and you won’t have to give up on options.
Banks don’t give anything away for free – they’re there to make money. That’s why it’s essential to discuss the full details surrounding the small print behind the low rates. It’s also important to take into account your longer-term goals and ensure your mortgage meets your unique needs now and into the future.
As always, if you have questions about mortgage rates, or other mortgage-related questions, I’m here to help!
News Release: February 4, 2013
HOME SALES SLOW TO NEAR HISTORIC LEVELS IN FRASER VALLEY AS BUYERS WATCH AND WAIT FROM SIDELINES
(Surrey, BC) – A total of 617 sales were processed through the Fraser Valley Real Estate Board’s Multiple Listing Service (MLS®) in January, a decrease of 23 per cent compared to 799 sales during the same month last year. January 2013 ranks as the second slowest for that month in the last thirteen years, second only to January 2009 during the global recession.
Scott Olson, president of the board, says there is a distinction between what REALTORS® saw four years ago compared to today. “People want to buy. We’re already seeing early signs of a typical spring market with more foot traffic at open houses and an increase in calls.
“Buyers have been holding off in hopes that prices will drop more, however it’s become clear that sellers are only willing to go so far. Prices for typical homes in the Fraser Valley have decreased by only two to three per cent in the last six months and in January we’re starting to see a reversal of that – in half of our communities prices have crept back up.”
Olson suspects the market stalemate may be coming to an end. “The number one reason people buy a home is a lifestyle decision – you need a bigger home, a smaller one, closer to work or school – so when the right home comes along you can only wait so long.
“With interest rates as low as they are, our local economy as strong as it is and prices so tenacious I think we’ll see the effects of this pent-up demand and a return to more balance in the market.”
In the last six months, prices for all three residential property types combined have decreased by 2.5 per cent while year over year they’re on par, showing an increase of 0.7 per cent. Of the three property types, prices of single family detached homes have been the most resilient, increasing 1.5 per cent in the last year going from $532,700 in January 2012 to $540,500 last month.
For townhouses, the benchmark price in January was $293,700, a decrease of 2.0 per cent compared to $299,800 during the same month last year. The benchmark price of apartments in Fraser Valley in January was $200,400, an increase of 1.2 per cent compared to $198,000 in January 2012.
REALTORS® added 2,643 new listings in January, 4 per cent fewer than the same month last year. This decreased the number of properties available in the Fraser Valley to 8,031, a decrease of 3.5 percent compared to January 2012. By historical comparison, January 2013 ranks as the third highest in terms of active listings in the last decade.
The Fraser Valley Real Estate Board is an association of 2,802 real estate professionals who live and work in the BC communities of North Delta, Surrey, White Rock, Langley, Abbotsford, and Mission. The FVREB marked its 90-year anniversary in 2011.
Full package: http://www.fvreb.bc.ca/statistics/Package%20201301.pdf