Thursday, 2 May 2013

A few final thoughts or mortgages.  Let's compare some scenarios.

First, let's look at upgrading your first home.  We'll imagine that you bought a home that you could more-than-afford with the intention of buying a home that you can't currently afford in the future.  Over five years your salary, and thus the amount you can spend on your mortgage, goes up 10%.  At the same time you build equity in your first house.

I calculated how much you would be able to afford to pay on that new home after five years, as a proportion of how much you paid on your first home.  This gives an idea of how much you will be able to upgrade.  The answer depends on how much you "underspent" on the first home.  The cut-off where you get a better upgrade with a high interest rate is around 90% of your maximum ability to pay.  That is, again, if you 300 currants a month then if you choose a mortgage that costs 270 or less then you'll be able to upgrade your home more with a high interest rate than a lower one.  If you pay 290 a month for your mortgage then you are better off with a low mortgage rate, if you pay 230 then the lower mortgage rate is much better.

As we saw before, a 10% increase in your payments on a mortgage with 12% interest makes a very big deal in terms of paying it back, but the same payment doesn't make such a big difference with lower interest rates.

Next, what if the value of your house goes up or down when you own it?  Remember in my first post that I specifically said that I was interested in houses as primary residences, which means that, generally speaking, the value of your house will go up and down with the market so the realtive buying power of your investment won't change that much over a short number of years.

I calculated a few different scenarios.  In each scenario you are selling your house and moving to a new one after five years.  We can look at three different possibilities - you are upgrading (buying a house of about 50% higher value), relocating (buying a house of the same value) or downsizing (buying a house of 30% less value).  We can look at the situation where you are maximizing your mortgage to pay the most you can for the house, and where you are buying more conservatively so that you can afford to pay your mortgage down faster (you contribute 10% or 20% more than your mortgage payment per month).  We can look at a situation where housing prices go up 20% or down 20% over those five years, where your salary increases 10% or does not increase, and where interest rates go up or down over that same time.

That's a lot to vary so I can't possibly lay it all out here, but I can do some of the basics.  I set the loan-to-value ratio at 95%, gave you a 10% raise over the five year period before you move, assumed you have to pay around 8% closing costs between fees and taxes, also assumed you were going to buy the biggest house that you were allowed to with your salary, and considered that you were willing to finance your new home at 25-years amortization (even though you were already 5 years into your original 25 years).  With a 3% interest rate you could afford a home about 15% more expensive than your original one in five years.  With a 12% rate you could only upgrade the value by 6%.

In my last post the magic formula for making 12% interest better was paying about 10% more than your basic mortgage payments.  So let's try those numbers again, but this time you only want to get a mortgage that is 91% of the size of the largest one you can afford.  Now with a 3% interest rate you can afford to buy a home worth up to 28% more than your original purchase.  With a 12% interest rate you can upgrade you home by 24% - much closer together, but still in favor of lower interest.  One of the biggest factors in this is closing costs, another is refinancing at another 25 years rather than 20 years.

If the market goes up or if it goes down it negatively affects your ability to upgrade your house.  I know that sounds odd but it if the market goes up and your salary doesn't go along then your ability to make a mortgage payment is reduced.  If the market does down then after only 5 years the sale of the place might not cover your current mortgage which will mean you can't afford a down payment on a new place.  With the other assumptions I've given, the market rising 20% or falling 20% means you will either have to stay put or downgrade your house.  At 10% you have very slight leeway to improve.  What is interesting, though, is that even with a maximum mortgage, w=the high interest rates are better for you than

the low ones whether the price of homes goes up or down.

If interest rates change by going up then having bought a home five years before is a bit of a problem.  You could find yourself unable to renew your mortgage because it is too costly to do so.  You are penalized by the higher price of money but don't benefit from the lower prices of homes.

If interest rates go down you get a big payoff.  The value of your home will rise as people can afford more and more, but the amount you have to pay won't go up a cent.

Since we can expect that consumer interest rates will never dip below zero percent and we know that historically they haven't gone above twenty, we can deduce that when interest rates are lower there is more room to grow and when interest rates are higher there is more room to shrink.

Overall through all of this I've found only one case where lower interest rates are better for home buyers.  That is the case where the home buyer buys the largest house they can possibly afford, pays their minimum payment only, and then wants to upgrade to an even larger house.  Of course that is only a good scenario if mortgage rates stay low.  If they go up, or if the market goes down, then this very unstable scenario leads to a disaster.  We've seen such a disaster quite recently.

In the end, low interest rates are not good for home buyers except for those home buyers who wish to always remain with large debt loads as they constantly move from one place to another over many years, always paying the most they can towards their mortgage.  These people, however, are essentially renters who have chosen to have hundreds of thousands of dollars in debt, they aren't really home owners because they aren't moving towards owning a home.

As I said before, if you are buying a home, all other things being equal, the lower the interest rate you can negotiate the better.  But the idea that interest rates going down is a good thing for you - well, "other things being equal" doesn't really hold up.



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