It should be obvious from the title of this post that I have no idea what I am doing with this blog. Basically the problem I've run into is that I don't have a lot of numbers to analyze in my life. I get to do a tiny bit of analysis at work, but really no one is interested in in-depth thinking about complicated issues. That's a big reason why I've been very attracted to video games, they give me complex systems to think about and I can apply my analysis.
The housing market is another complex system that I live with. Not that I am a great buyer and seller of real estate, but I do own real estate and I do have a mortgage to pay off. And since pretty much all analysis of home buying is done to confirm the biases of banks or political parties, why not take a meaningful look at the effect the low interest rates really have on an individual's position in the housing market.
Because that's really what's missing from the perspective taken on low interest rates by the reports you see in the media. You aren't a speculator (if you are, then enjoy your fountains of cash), you are a person who needs a place to live. You are going to have to pay for that place to live either through rent or by purchasing it. When you sell that place to live you are going to have to rent or purchase another place to live. When you die your inheritors might sell the place you own and split the cash, but while you are alive you are always going to need a place to live.
So people with financial backgrounds tell us the most obvious thing in the world: If you are going to take out a huge loan, the lower the interest rate the better it is for you.
They then translate that into the statement: Interest rates are low, it's a good time to buy.
But there is a missing premise in there. To get from A to B, you need to include the following: The interest rate is not going to affect the size of the loan you need to take out.
And that just isn't true.
If you are buying a house in Canada then your mortgage will likely be insured by the Canadian Mortgage and Housing Corporation. In order to be insured the mortgage must follow certain rules. You need a down payment of a certain size, the amortization period must be below a certain amount, the monthly payment can't exceed a certain fraction of your income. If you are not in Canada you will not be subject to CMHC rules, but presumably whatever bank you are dealing with will have their own rules; it's a lot harder to find a zero down mortgage with no proof of income today than it was in 2006.
What's important to understand is that while we usually think that our mortgage payments are determined by the size of the mortgage we take out, it is just as valid to think that the size of the mortgage we can take out is dependent on what we are willing to pay each month.
So how much is this house you want going to cost? Because it is essentially up for auction, it is going to cost you however much the next most interested buyer is willing to pay for it. The particular auction system probably means it's even a little more expensive than that, but we'll ignore that difference for now.Who is this next-most-interested-buyer? They are most likely someone who, like you, needs a mortgage to buy their home. They are, therefore, most likely someone who is subject to the same mortgage rules as you are - they have equal access to good mortgage rates, they have to put down a down payment of a certain size, and they have to have an income high enough for the bank to approve their mortgage payments.
Furthermore, they may be someone who makes pretty much the same amount of money as you do - after all, they found themselves looking at a house with the same list price as you. Besides, if they have far less money than you then they are not really a competitor for the home. If they have far more then you aren't really a competitor.
Let's say your house-competitor both make 1000 currants a month. The CMHC says the most they are allowed to pay for their mortgage is 30% of their income - 300 currants (it's actually 32%). The CMHC says that they you are allowed to amortize the mortgage over 25-years. The bank is offering a 3% fixed rate.
So how much is your house competitor able to pay for the house? They can offer 63,545 currants. So, if they really want the house, you are going to have to offer more than that. What would happen if the bank were offer a 12% fixed rate? Then your house competitor would be able to offer a maximum of 29,756 currants.
Note that either way, in order to match that offer what you need to do is pay 300 currants a month for 25 years at the end of which you own the house. In one scenario you own a house that you paid 63.5k for and in the other you own a house that you paid 29.7k for, but let's remember that what you really own is a place to live where you no longer have to make mortgage payments.
Pay off your mortgage faster!
"But," the standard thinking goes, "With lower interest rates you can pay off your mortgage faster!" This is somewhere between completely false and an outright lie.
Here is what it means that you pay down your debt faster with a lower interest rate. Say you buy that house for 300 currants a month over 25 years. If interest rates at 3% then after 10 years you will have paid off nearly 32% of your total debt. If interest rates are at 12% then you will have only paid off 13% of your total debt. That first case sounds a lot better, right?
But remember, at 3% your initial loan was 63.5k, while at 12% it was 29.7k. The actual amount of money you still owe after 10 years is 43,565 currants if the interest rate was 3% but it's only 25,840 currants if the interest rate was 12%. And remember that you still have the same income as you did, 1000 currants a month.
Though you pay off your debt faster as a percentage, at all times your actual debt will be higher because the loan was larger to begin with.
It's quite possible that you can pay more than the guidelines say for your maximum payment. Just because the bank won't give you a mortgage with a monthly payment more than 300 currants a month doesn't mean that you can't set aside another 10, 20 or 30 currants to get out of debt faster. Suppose you can pay 30 currants more, so you are able to pay 10% more than your required payment - let's also assume that your bank allows you to do this, but I think at this point most mortgage agreements would allow at least this much flexibility.
If you can pay 10% more than your mortgage payment then under a mortgage at 12% you will be paid off in less than 15 years. If your mortgage rate was 3% then you'd still be in debt after 20 years - you would barely finish paying your mortgage any faster at all. Suppose instead you could increase your payment by 25%. In that case the 12% mortgage is done after 9 years while you'll still be paying off your 3% mortgage for more than 15.
Conversely if you reduced your payments a person with higher interest rate would suffer more than a person with a lower one, but if you can't make your mortgage payments then the consequence is the same regardless of the interest rate.
A similar result is that if you want to be mortgage free within 10 years instead of 25 you can make a much better offer at 12% than at 3%. In the 12% interest rate housing market, the person who wants a 10-year mortgage can pay 72% of what the person willing to take a 25-year mortgage can. This certainly means they get a smaller place. with 3% interest wanting a 10-year mortgage means that you can only pay 49% of what you'd be able to pay for a 25-year mortgage. You probably can't afford anything in remotely he same category.
But wait, you say, what about the next best alternative? After all, you could invest that money instead of paying down your mortgage and if mortgage rates are higher than you could get more interest for your investment. There are two problems with this line of thinking. First, it is unlikely that you can invest money at a higher interest rate than the interest rate the bank is charging on mortgages. The bank is in the mortgage business to make money, if they could invest the money elsewhere and get more back from it then they wouldn't need to give you the mortgage in the first place. But if you are just the sort of genius who sniffs out incredible investment opportunities (you are almost certainly not, by the way) then those investment opportunities are going to pay you more if interest rates are higher. Since the amount of money you have to invest is a fraction of your paycheck, not a function of interest rates, the higher the interest rate the better it is for you as an investor.
Someone might argue that we do not see this direct relationship between housing prices and interest rates. Housing prices did not go down when interest rates went up in the 80s and they did not go up massively when interest rates went down. Furthermore, in recent years in many places housing prices have gone up a lot even though interest rates, inflation and wages increases have all remained very low.
To that I point out that I am using a very simple model to show the effect of asingle variable. Reality is much more complex. Looking at interest rates and home prices they are at least correlated in the right way. The price of homes is very heavily influenced by things like CMHC and banking practices, as well as wages.
It might also be argued that while lower interest rates will push prices up over the long term or in a steady state, it is still the case that if interest rates are lower this week you are better off this week than last week. In a way that's true. If you negotiate the whole deal and fix the price of the home and then go to the bank and find out that they are going to charge you a lower interest rate than you thought then you a better off paying less. But I don't think it takes a huge amount of time for interest rate changes to creep into housing prices. As long as people are competing for houses, the maximum amount each person can afford will affect the actual amount paid. The maximum amount that a person can afford is affected instantly by a change in rates.
Next time I'm going to talk about down payments. As far as I can tell, they are either a wash or they once again favour high interest rate environments.
I am not a financial professional and I would love to hear why I am wrong.