Welcome to part 3 in an escalating series of ‘what if’s’.
Please Note; I’m personally skeptical we will see any significant interest rate hikes over the next five years. (significant being more than 1% – 2%).
And given that borrowers were/are qualified at a stress test rate of 5.25% (currently) the system is built to easily handle such an increase.
It’s also worth noting that it took a decade following the 2008 economic crises for rates to edge into the high 3’s.
Yes yes, of course ‘this time could be different’.
Although, when the Bank Of Canada had it’s small run of (five 0.25%) rate hikes from mid 2017 to late 2018 it seemed clear to many throughout 2019 that rates had moved at least one 0.25% hike too far too fast.
It was around that time that I put out the first version of the ‘two bets’ video re fixed vs. variable.
In any event, there was no better evidence that rates were a touch too high than just how fast the BOC dropped the overnight rate via an emergency 0.50% cut on March 6 of 2020, and then within just a few weeks taking the overnight rate all the way down to 0.25% where it remains today.
But let’s get down to it and answer the question in my own ‘inflammatory’ headline;
What happens if interest rates quadruple?
Well, let’s do some math and see.
Does 4X the rate mean 4X the payment?
2X the rate = a payment increase of ~20%
3X the rate = a payment increase of ~40%
We can see a pattern here.
Note; A 25 year AM is used both to be conservative and to capture the (mostly) first time buyers with less than 20% down.
Today (Aug 2021)
Mortgage Rate AM Term Payment Balance at renewal
$100,000 2% 25yr 5yr $423.45 $83,770
Renewal Time (5 yrs from now)
If rates have quadrupled;
Mortgage Rate AM Term Payment Balance at renewal
$83,770 8% 20yr 5yr $693.92 $73,185.00
Currently in Canada the average new mortgage balance is $400,000.
To qualify for a $400,000 mortgage requires $80,000 gross income.
After tax this is $5,000 cash in hand each month.
Thus a $1,700 payment leaves our borrower with $3,300 per month to cover groceries, and other necessities until 2026.
Now, if we are going to play this game, suggesting the 5yr fixed rate has increase from 2% all the way to 8% by 2026 which is well… a bit of a stretch.
Then it fits that the economy must be booming, as interest rates are increased specifically to slow an economy down, and as we’ve already seen quite clearly in 2008 and again in 2020 – in the face of economic crisis, in the face of spiking unemployment, rates are cut to rock bottom levels, they are not boosted to higher levels.
So to jack rates up higher than we’ve seen in nearly 30 years, things would really have to be running wild, which would also mean your income will have increased somewhat. That’s part of how inflation works.
So it’s more than reasonable to allow that our borrowers have received at least a 2% annual raise.
Taking the after tax cash-in-hand up to $5450 per month, and while $450 net new money is not going to completely offset the payment spike we are speaking of here, how bad is it really?
Our borrowers started out with $1700 payments against $5000 net cash in hand. They had $3,300 left over each month.
They now have a mortgage payment, at renewal with 8%, of $2800.00 set against $5,450 leaving them with $2,650.00 each month.
Once again, I’m going to highlight that for a household composed of one person, of which there are four millions such households in Canada, the mortgage payments would clearly continue to be made. A lone individual can certainly manage on $2,650.00 after housing costs.
This would admittedly be putting a major squeeze on a household of 3 or more. Although it would still be doable. There’s just no more dinners out, at all.
And that last comment I made, that is the real concern of our government. Their concern is not about Canadians failing to make mortgage payments, their concern is about Canadians ONLY making mortgage payments. This specifically is what drove the creation of the stress test, not concerns about foreclosure or real estate market implosion. Concerns around the broader economy.
Previous regulators have touched on this point, but it’s never really been highlighted anywhere mainstream. This quiet unspoken truth around mortgage guidelines being influenced by macro-economic viewpoints and policy initiatives designed to keep the GDP in line… as well as Gross Domestic Consumption.
There is a lot more to keeping an economy going than most of us understand, so while things may seem overly prudent and it may appear we are just ‘stress testing’ applicants to be safe, to ensure stability for lenders, etc. The real story is that the Fed would prefer to see would-be-homeowners giving up on dreams of ownership and taking their savings, their would-be down payment money, and spending it on ‘things’, because consumption is what holds our economy together and if the economy holds together then the country holds together.
There is a much bigger play here than many of us realise.
This is why we see so little logic in mortgage underwriting, it’s not that the lenders don’t trust you, or don’t want to lend you the money, the lender does trust you, and they do want to charge you interest on a loan – very much.
However the Federal Government has bigger fish to fry, and the Canadian obsession with home ownership is a real challenge for them as far as keeping the economy running. Because what are you doing when you make mortgage payments?
You’re paying off an asset that is already built and sold.
Making mortgage payments does not stimulate the economy, it’s just shy of sticking the money under your mattress. More Canadians making mortgage payments is in fact a bad thing for the economy, or so the Fed seems to think. This is a slice of what really happening behind the scenes.
And this of course plays right into what the math above shows, even at 4X today’s rates, we will not have a full blown crisis with tens of thousands of people deciding to sell, at a loss no less.
No, instead there’d be a lot of talk about 1981/82, but even more talk about 83/84, because while rates shot up from 10% to 21.46% very quickly, they also fell just as fast.
We would weather that storm. somehow.
Should I keep going? Should we do the math on a 5X interest rate hike? Or are we seeing that even in the face of very significant interest rate spikes… we will in fact survive.
Let’s try and remember this when the Bank Of Canada finally bumps the overnight rate by 0.25% and headlines everywhere predict ‘the beginning of the end!’