Interest Rate Reset Risk

[Greenhorn]

THE RESET RISK

Easy money, eager buyers. What happens if rates go up?

http://www.globeinvestor.com/servlet/st ... 4/GIStory/

STEVE LADURANTAYE
Wednesday, November 18, 2009
REAL ESTATE REPORTER

Mike Averbach says he has never been busier.

The Vancouver mortgage planner has been doing brisk business lately as would-be homeowners scramble to secure cheap mortgages to get in on a real estate market that has quickly and sharply rebounded from the economic slump.

The flurry around Mr. Averbach's business illustrates the efforts some first-time buyers are going to in order to win rich bidding wars.

It's these buyers who have raised fears of a bubble, negotiating mortgages at historic lows, opting for 35-year terms and making small 5-per-cent down payments to keep monthly outlays down and put previously unaffordable homes within their reach.

"They are taking advantage of things that are a lot more attractive initially but they could find themselves in a position where they couldn't afford their mortgage if rates start to go up," Mr. Averbach says.

While home buyers have been pulling the housing industry out of a slump with their enthusiasm, there is growing concern that today's price gains, fuelled by cheap money, may be setting the stage for a different sort of crisis two to five years from now when their mortgages reset at higher rates.

These homeowners could be forced to put their houses on the market and sell them for less than they paid, dragging down prices everywhere.

Toronto and Vancouver in particular have seen prices climb in the double digits this year, up 20 per cent and 14 per cent, respectively.

"In the short term, these variable rates are pure gravy to borrowers," said Scotia Capital economist Derek Holt. "But rates start to go up, and you will likely see some people have stretched themselves beyond their limits."

Mortgage rates typically increase after the Bank of Canada adjusts its key lending rate and bond rates move higher. The central bank has vowed to keep rates locked near zero until mid-2010, although some believe it could move sooner if inflation begins to appear.

"It's a safe thing to say that interest rates tend to move higher a lot faster than they move lower," said BMO Nesbitt Burns chief economist Doug Porter. "And there is always an outside risk that we could end up with more of a global inflation problem than many are predicting and rates could rise dramatically."

For example, a five-year variable rate mortgage at 2.25 per cent on $300,000 would carry a monthly payment of about $1,300, assuming a 25-year amortization period. A move to 5 per cent would boost the payment to $1,750. It's a 34-per-cent increase, something Mr. Holt said many family budgets wouldn't be able to accommodate.

"Our concern is that the majority of new buyers are going with floating rates and setting themselves up for gradual and material rate resets over the next two years," Mr. Holt said. "Buyers need to think about where their rates could end up and whether they would be able to make those payments down the road."

Not everyone fears a bubble. Some economists believe the resurgent market is the result of supply and demand - buyers simply stayed out of the market at the beginning of the year and are making up for lost time.

Phil Soper, chief executive officer of Royal LePage Real Estate Services, said the recession has driven prices higher as low rates have drawn buyers into the market, but economic uncertainty has kept the number of new listings constrained. He expects prices to cool down as more supply hits the market in the coming months.

Those price gains are only sustainable if the country is indeed in the midst of an economic recovery, he said, something that is far from certain.

"If we are in a recovery then people can adjust to higher interest rates relatively easily," he said. "That's certainly what policy makers are counting on. That's what we're all hoping for, but we don't have a crystal ball. That's not the way it necessarily has to happen."

While prices could pull back as interest rates rise in tandem with a stronger economy, economists don't expect to see the type of contraction that led to the housing crisis in the United States. The Canadian system is much more stringent, and mortgages aren't as easily obtained - though a near-record $186-billion of new mortgages will be issued this year, according to the Canadian Association of Accredited Mortgage Professionals (CAAMP).

"The overwhelming majority of Canadians still have predictable fixed [rate] mortgages and a fair bit of skin in the game," said CAAMP CEO Jim Murphy. "In the U.S., people had no equity, or could get loans without jobs. We don't have that kind of volatility here."

Indeed, low rates have been a boon for those who are renewing their mortgages. Shane O'Neill, a Vancouver-based human resources worker, managed to save $1,000 a month by switching from a fixed-rate mortgage at 5.5 per cent to a variable rate at 2.25 per cent. If interest rates suddenly jump, he intends to lock in at his old rate.

"I've owned the place for seven years and have been fixed all that time," he said. "I just couldn't handle the variable, all the stress of not knowing where rates would go. But they have to go up a fair bit here before I start to worry again."

***

Higher Rates and You

Here's an example of how rising mortgage rates could cause a big increase in costs for someone buying a home today.

Particulars: A $250,000 five-year variable-rate mortgage with accelerated bi-weekly payments

Fall 2009: Your new mortgage

Balance $250,000
Amortization 25 years
Mortgage Rate 2.25%
Payment $545

Fall 2014: Renewal time*

Balance $204,726
Amortization 17.5 years
Mortgage Rate 6%
Payment $784
Increase in payments after 5 years 43.80%

*the assumption is you'll take another five-year variable-rate mortgage

Source: canequity.com

© The Globe and Mail

[MikeStewartRealtor]

Hi Greenhorn,

What about pushing out the amortization to keep the payments low?

The person in the example was able to pay off a huge amount in the first 5 years. If they push out their amortization they can keep their payments low and will be paying off (hugely reduced due to historically low rates) principal in a manner typical of more normal rates.

[Greenhorn]

Hi Greenhorn,

What about pushing out the amortization to keep the payments low?

The person in the example was able to pay off a huge amount in the first 5 years. If they push out their amortization they can keep their payments low and will be paying off (hugely reduced due to historically low rates) principal in a manner typical of more normal rates.

Hey Mike! That is always an option in your back pocket. Good point. You can go back to 25 years or get it CMHC insured and push it out to 35 years. At refinance time, the borrower could always pay down the mortgage if they have cash on hand. Also, the borrower's income should be 20% higher based on modest raises each year.

[Taipan]

Simple interest rates up at least 1.5 - 2.0% and that is before they blink.

[metalhead]

Sure, in fact you could keep pushing it out every time you renew and let your kids pay it off.
Even better.

[registered]

And pay even more for your home. But paying more makes it worth more, right? Right?

[MikeStewartRealtor]

Hi Greenhorn,

Good to hear from you!

My thoughts exactly.

These ultra low rates are a great opportunity to pay down a mortgage. If I was the person in the example, I would up my payments to the highest amount manageable from the get go to pay down as much as possible while rates are low, so that when rates go up, I'd be able to push out the amortization and let the inflation that caused rates to rise, eat away at the relative value of the mortgage.

What are your thoughts?

M

[eyesthebye]

And pay even more for your home. But paying more makes it worth more, right? Right?

exactly! The more homes sold at these higher prices, the less likely you'll find one for les money in the future...and there are a lot of homes being sold at these values.

[metalhead]

More "Buyer beware" stuff from Canadian Business magazine.
If not beware at least be prepared.


http://www.canadianbusiness.com/markets ... 999&page=1

Consumers need to prepare for higher mortgage rates next year: advisers
By Kristine Owram, The Canadian Press

TORONTO - The Canadian housing market has seen a stronger and faster rebound from the recession than any other segment of the economy, due in large part to enticingly low mortgage rates.

But rates this low - 5.59 per cent for a five-year fixed-rate mortgage and 2.25 per cent for a five-year variable-rate mortgage at one bank - can't last forever, and experts are advising borrowers to prepare for higher rates within the next 12 months.

"We have to realize those are emergency interest rates," said CIBC economist Benjamin Tal.

"Interest rates will rise - it's just a question of time, it's not a question of if. And if that's the case, we have to make sure that when we borrow this money we can afford the same mortgage 200 or 300 basis points higher. That's the key responsibility now of borrowers and lenders, to make sure that what we do, we do it in a prudent way."

snip.......................

[Greenhorn]

Hi Greenhorn,

Good to hear from you!

My thoughts exactly.

These ultra low rates are a great opportunity to pay down a mortgage. If I was the person in the example, I would up my payments to the highest amount manageable from the get go to pay down as much as possible while rates are low, so that when rates go up, I'd be able to push out the amortization and let the inflation that caused rates to rise, eat away at the relative value of the mortgage.

What are your thoughts?

M

In theory, this sounds good and is probably something a prudent person would do. What I like to do is have a regimented savings plan to build up a sinking fund. When the mortgage matures, I can decide whether to pay down the mortgage or increase it depending on where rates are at and what other uses I have for the money.

The problem that concerns me today is that most people are not disciplined and are gorging themselves on all this free money. They are at the limit. A lot of people are barely qualifying for the loan amounts they need at a 2 year rate and a 35 year amortization. This is a ticking time bomb. People think that having savings or creating savings is not necessary because their homes will increase in value at 10% per year for ever.

People are spending more than they make.

[MikeStewartRealtor]

Hi Greenhorn,

Good to hear from you and sorry for the delayed response. Your answer gave me much food for thought.

I do have the same concerns. But what can be done aside from tightening lending criteria (which already has happened) in a free market economy as ours?

I like your idea of a sinking fund. The only concern I have is that the returns on that fund may not be more than the interest you could have saved buying off the same amount of mortgage.

What are your thoughts?

[pianoexcellence]

I do have the same concerns. But what can be done aside from tightening lending criteria (which already has happened) in a free market economy as ours?

What are your thoughts?

I share your concern.

What can be done? I'm not so sure it is about what can be done. I think it is about what has been done. There will be some sort of consequence when the rates rise. I'm hoping it will be a very slow controlled re-alignment with gradual price decreases. No blood on the streets. I have to admit that even I as a bear was getting uneasy back in Dec 2008.

Of course i'd like to see my liability as a taxpayer (co-signor) of cmhc be reduced. I'm sure as heck not planning on the Govt taking my side on this though. I would also like to see interest rates rise...I am OK with the fact that I will be bailing out people who bought homes that they could never afford...whatever, that's life in a quasi-socialist country like ours.

No sense complaining...but what can the smart person do to avoid huge personal financial damage?

I suggest good old fashioned prudence. If you must buy...buy what you can afford...even at 10% interest rates. If you are flexible...I think it is a good time to sit out the market (rent) and put your money somewhere safe (if you expect deflation) or put into hard assets other than overpriced BC RE...maybe buy 10 condos in LV for the price of one in Van, or buy oil (if you expect inflation). I get jittery when it comes to Gold...but who knows....

Of course, this is just my 2 cents...my timing record is OK but not bulletproof
---pre-sold squamish vacation condo may 2008
---sold abbotsford PR in June 2009
---Cashed out of all RRSP's and tsx investments in Jan 2008
---back in TSX in jan 2009 (oil, fertilizer, mining)

-p-

[vreaa]

casual observer at greaterfool.ca mentions a method of getting away without a down payment -

“They didn’t have to come up with a down payment.”

“If you go into one of the big five banks, and take their posted rate on a mortgage, they will GIVE you the 5% down payment. CMHC is happy because the 5% DP has been paid, the bank is happy because they get a higher rate on the mortgage, and the buyers are happy because THEY DIDN’T HAVE TO COME UP WITH A DOWN PAYMENT. And it’s all legal and above board. CMHC just charges a premium for a “NON-STANDARD Down Payment”. Now if that’s not a zero down mortgage, I don’t know what is. I know people that have done this within the last couple of months, but none of the media seems to want to bring attention to this.”

[ianmills]

What about pushing out the amortization to keep the payments low?

The person in the example was able to pay off a huge amount in the first 5 years. If they push out their amortization they can keep their payments low and will be paying off (hugely reduced due to historically low rates) principal in a manner typical of more normal rates.

You are conveniently forgeting the drastic decrease in house value as interest rates increase. I for one have also wanted to pay more and more for something as it loses value...

[MikeStewartRealtor]

Hi Greenhorn,

The people I am working with are not at the limit and I would say 70%+ are low ratio and most of these people are working with a lot of equity.

I don't come across people very often who are limiting what they do from a lifestyle perspective so they can have more Real Estate. People tell me they want to have money/time to do the things they value and they buy property they can comfortably afford.

The people I work with see the low rates as a way to pay off their mortgages quicker or keep payments lower than they normally would be and don't use it as a means to buy something they couldn't afford. These people tend to be very cautious with property transactions and how they finance these transactions.

This caution could be seen in how rare foreclosures were in my market during the economic crisis. This prudence and caution was the reason for this.

What are your thoughts?