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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…

…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. 

(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.

________________________________________

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.

Raymond Lee | Director of Business Development

C: 416 540 7364  TF: 1 877 210 4498

Email: Raymond.lee@merixfinancial.com

Website : www.merixfinancial.com

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