Mortgages and Interest Rates

Mortgages and Interest Rates

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:

TSML Mortgage Rates

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:

TSML Mortgage Rates 2

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.

3 thoughts on “Mortgages and Interest Rates

  1. It looks like 7% is a defining line for a lot of people 🙂 Too bad we can’t buy homes with 35 year mortgages anymore. But maybe that’s a good thing lol. I wonder what the average rate would need to be on a 35 year amortization for the interest to exceed the principle.

    I’m not sure when interest rates will rise, but I think when they eventually do it will be slow and drawn out. I don’t think the BoC will risk jeopardizing the housing market by tightening too quickly. Makes me wonder though: where would home prices be today if Prime was at 5 or 6 percent? 🙂

    1. If Canada had ~3% 25-30 year fixed rate mortgages like in the States, I would take that and run and buy whatever without a care in the world.

      To be locked into such a historically low rate for decades would be beautiful 😀

      1. And don’t forget it’s tax deductible, to boot!

        Even though rates are ultra-low right now I opted to double my mortgage payments for the first few years to hammer down the principal. Just a hedge in case rates are much higher when it comes time to renew.

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