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How Interest Rates and Amortization Periods Help Us Accept Appreciation

Affording a home is less about average prices, and more about typical monthly payments, argues mortgage broker Dustan Woodhouse

By
Mortgage Expert
April 11, 2016






Percentage of money

This blog first appeared on Dustan Woodhouse's website. To read the original article, click here.


If you are offered a bottle of water for $2.00 just after breakfast, you will likely say no thanks. Perhaps you’re not that thirsty and you will have time to grab one later. Besides, there are lots of taps around.

If a few hours later you are offered a bottle of water for $3.00, you are likely to say not a chance, even though you are now a bit thirsty, pressed for time, and nowhere near a store or tap.

Principle enters the picture at this point. You could have had the bottle for $2.00 just a few hours earlier. As we get into late afternoon, having worked through lunch, you finally cave in and say yes you will buy the water, but of course now it is $4.00. What?!?!?

This is the crossroads. You either dig in with that $2.00 price stuck in your head, and no damn way do you pay double, after all this is crazy, the increases are unsustainable, and clearly people have lost their minds… or you find acceptance that not only do you need water, but clearly it may well be $5.00 by tonight.

Applied to our real estate market, more people are accepting the new reality and buying than are not. The record sales stats each month make that clear.

The Numbers (don’t confuse me with your logic)

Part of the rise in prices – not nearly all of it, but part of it – can certainly be traced back to falling interest rates.

Odds are if you think today’s market is crazy-town, then you probably took your first mortgage out at six per cent or higher, and indeed those payments would have been tougher to make had the home been 50 per cent more expensive. One needs to look at the ratio between purchase price and payments to get a firmer grasp on how these higher prices can be tolerated.

Interest-Rate-to-Payment Math

$200,000 @ 12%              $2,063.80 per month

$320,000 @ 6%                $2,047.38 per month

$450,000 @ 2.49%            $2,013.61 per month

*all calculated at 25-year amortizations.

As you can see, if you are financing 95% of the purchase price of a home, it actually costs you less with each price hike, if the cost of borrowing drops at the same time.

It is less about the purchase price than the payment. At all three purchase prices, the payment is pretty much the same. This makes home buying today, in comparison with yesteryear, more affordable that was first thought.

But what happens when rates go back up…?

It is not when, it is if. I wrote that correctly.If they go up – as in, if they go up in time to matter to me, or to Mr & Mrs Homeowner. Maybe they stay low for another 10 or 15 years, and by then my mortgage will be so low, and my income likely increased, that higher rates won’t impact me directly.

Some basic math about today’s mortgage applicant and what happens after the five-year term is up:

That $450,000.00 mortgage at 2.49 per cent, at the end of the five-year term, is paid down to $380,793.81.

If rates are up one per cent

$380,793.81 @ 3.49% =  $2,201.59 (*20 year amortization)

A very modest increase in monthly payment. It is reasonable to suggest that come renewal time, five years later, that our average clients’ household income will have increased by at least $187.98

If rates are up two per cent

$380,793.81 @ 4.49% = $2,398.53 (*20 year amortization)

A bit steeper increase, but again, is it reasonable to think that a family that has the $75,000 income required to qualify for a $450,000 mortgage today (you read that correctly) will have an extra $384.92 per month five years from now. This, too, is a pretty minor income increase over a five-year period.

The Amortization Effect

Missing from this increasing interest-rate scenario is something totally unspoken of in the media, and that is the fact that, as rates rise, the Federal Government will almost certainly increase amortization length. Just as they strategically shortened it since 2008 as interest rates fell.

So if, at 4.49 per cent, our theoretical family could not take the squeeze of a $384.92 increase, they will almost certainly have the ability to stretch the amortization back out to 25, 30, 35, or even our old friend the 40 years . This would dramatically lower payments and keep people in their homes, easily.

Each year from 2008 through 2010 the Federal Government reduced the maximum amortization as follows.

  • Less than 20 per cent down: formerly 40-35 years, reduced to 30-25 years.
  • At least 20 per cent down: formerly 40-35 years, reduced to 30 years

With less time to pay off a mortgage, the monthly rate is higher.

The effect of reducing the amortization by five years had an increasingly powerful effect. In the case of the final move, from 30 years to 25 years, it was effectively the same as a one per cent interest-rate increase.

Mortgage            Rate     AM       Payment

$100,000             4.49       40           446.26

$100,000             4.14       35           449.08

$100,000             3.49       30           447.09

$100,000             2.49       25           447.47

In other words, today’s buyers putting less than 20 per cent down with a maximum amortization of 25 years at 2.49 per cent qualify for no more mortgage money as they did with the longer amortizations of 2008 at 4.49 per cent rates.

Your income only qualifies you for X amount of a monthly payment. The payments are the same today at 2.49 per cent as they were in 2008 at 4.49 per cent. And so the mortgage balance is the same too.

Today’s low interest rates do not allow you to qualify for any larger mortgage than you did in 2008.

Interest rates are less of a fundamental behind this boom than people realize. The effect of low interest rates has been dampened by reduced amortizations.

For mortgage qualification, little has changed over the past 10 years. Except perhaps that more people are now actually borrowing closer to the maximum of what they can qualify for than before.

Conclusion

The reality is that people who buy homes here clearly can afford them. Look no further than the month-after-month record sales volumes in all categories and in all areas of the Lower Mainland.

What is ridiculous is to use a metric for commentary such as home-price-to-average-income, in a city in which 47 per cent of homes are mortgage free, and for those with a mortgage, have an average balance close to $420,000.

Perhaps a median-income-to-median-mortgage-balance metric should be considered.

Disclaimer

Some might suggest I am simply trying to fuel a market for my own gain. This makes little sense. I am not a REALTOR® and need zero price appreciation and zero purchase/sale activity to earn my living. Refinance transactions at renewal time alone keep me busy.


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