Buying a home is one of the biggest financial decisions most people will ever make. Taking on hundreds of thousands of dollars worth of debt to purchase a home is an immense decision that shouldn’t be approached casually. There are a myriad of factors you must consider before leveraging so much money for a single, illiquid asset. This is especially important in a “hot” real estate market like Vancouver.
To be completely honest, I am apprehensive about purchasing any kind of real estate in the Vancouver market. Yes, yes, I do believe it’s overpriced. But we won’t hash out that debate in this post. What I want to focus on here is interest rate risk.
Interest rates have been at historic lows since the 2008 recession. Governments lower interest rates in order to facilitate economic growth by making credit available at lower rates. The theory is that people will respond to lower rates of credit by borrowing money to fund economic activity.
Low interest rates have led to low mortgage rates. Mortgages are available at historically low rates. For Gen Y readers, ask your parents about their interest rates in the late 1970s-1980s. For those who held mortgages in the late 1970s-1980s, recall the high, high interest rates you paid on the mortgage.
Now, this isn’t a forecast about where interest rates will go. No one can predict the future. And no one can predict where interest rates will go. However, if interest rates have been at historic lows, they can’t really go any lower. So there are only 2 options: it will remain low or it will eventually start to climb.
The danger of being highly leveraged in a low interest environment is that if interest rates suddenly start climbing, your debt and the payments on your debt become magnified. Let me show you in this table below:
The table shows the total interest you would pay over a 25 year amortization period for 3 different price-tier homes. We are currently in a prime rate environment of 3%. So for simplicity sake, let’s assume you can get a mortgage for 3%. Now, observe carefully how the interest owed magnifies as interest rates increase percentage-by-percentage.
7% is highlighted because a mortgage rate of 7% is where the total interest owed on the mortgage exceeds the value of the home when it was bought. I’ll provide the graph again to provide a visual for the table above:
My take aways from this exercise are:
1) High leverage in a low interest rate environment can have dramatic consequences if interest rates rise.
2) Affordable mortgage payments can quickly become unaffordable payments if interest rates rise.
3) I would be so sad if the total interest paid on a loan exceeded the value of what I had bought.