Mortgage Interest

September 16th, 2009 by Potato

Since I know some of you at least haven’t picked up a calculator since high school, let’s go through a very quick simplified calculation of mortgage interest and payments. Just looking at a very simplified version of the formula, your interest per month = principal due * (yearly interest rate / 12). Like I said, very simplified. So, if you have a $400k mortgage, and your interest rate is 2%, you owe about $667 in interest every month. If your rate goes up to 3%, that’s $1000/mo. At 4%, $1333 — double what 2% was, which is pretty obvious for this simple case. At 6% you’d be paying $2000/mo in interest, and at 8% $2667/mo.

Of course, that isn’t what your mortgage payment is, since you also have to repay some of the principal that you borrowed each month so that by the end of your amortization period (whether that’s 35 years or something shorter, like a more traditional 25 year period). Let’s say that you paid an equal amount back towards the principal each month. Without interest, that’d be 400k/(25*120) = $1333/mo. Of course, you don’t pay down your principal in equal installments: mortgages are generally set up so that you have a fixed payment for the duration, part for interest, and part for principal, so that at the beginning you’re paying mostly for interest, and at the end you’re paying mostly towards principal.

At this point we could continue doing the calculations by hand, but that’s going to detract from what I’m trying to draw attention to, so let’s instead make use of an online mortgage calculator:

    At 3%,

  • a 25-year mortgage has payments of just under $1900
  • and at 35-years, payments of $1540.
  • At 5%,

  • a 25-year mortgage has payments of $2340
  • and at 35-years, payments of $2020.

So when the rates were dropped to the bottom during this financial crisis last year, a 35-year mortgage got roughly 24% cheaper. This, to a large extent, has been what’s keeping the Toronto market afloat this year. To me, that’s crazy, because those monthly payments are only low as long as the rates are — once interest rates go back up, so too will the payments. People at large though are short-sighted and focus on the monthly payments rather than the actual cost. But what’s more bizarre is this quote from the Star’s real estate section:

“Those are very robust numbers,” said Toronto housing analyst Will Dunning. “Part of this seems to be fuelled by the fact that some buyers fear interest rates will go higher next year and are buying now rather than taking a chance on next year.”

If you fear rates will go higher next year, why rush to buy now? In Canada, you can’t “lock in” a low rate, at least, not long enough for it to really matter. While you might be able to find a lender that offers a 7- or 10-year term, for all practical purposes the longest you can lock in your rates for is 5 years. Five. Short. Years. And to lock in for that long, you often pay a premium rate, which largely factors in modest rate increases anyway. Right now you could probably get a variable-rate mortgage for less than 3%; a fixed 5-year would be over 5%. A 2% increase in rates is already factored in, and you get to start paying that right now. What is locked in?

Your principal.

The amount you actually pay for the house. 5 years from now when it’s time to get a new rate, you’ll have paid down… not very much on your 35-year mortgage. You’ll still owe about $375k of your original $400k if you had the 5% fixed rate — barely 6% of your house is paid off after 5 years. You’re still just as vulnerable to rates going up, since your principal is still virtually the same. If rates did go up, people focused on that monthly payment would probably bid less for a home, since they couldn’t afford any more (even with the low rates, we’re at the bleeding edge of affordability in Toronto) — this is why house prices generally move opposite to interest rates (as rates go up, prices come down).

Unfortunately in our world of cheap debt and rules of thumb, people mostly pay attention to this monthly figure, in the here and now, and think little of what the future might hold and how they might need to manage their risk. And we are at (or very close to) the point of maximum risk here: housing prices can’t go up forever. After all, someone has to keep buying, so everyone can’t be priced out forever. More importantly, interest rates can only go up from here. The overnight rate from the Bank of Canada is essentially zero right now, and bond yields are low — mortgages will not get any cheaper. And just as lower mortgage rates made the monthly payments lower for buyers, higher rates will make them, well, higher. Much higher.

So we return to the case of the forced savings, those unfortunate individuals (and yes, this describes some of my friends) who simply can’t manage to budget and save, so by buying property and paying down the mortgage they’re building equity, a forced savings program. However, if they’re already pushing the boundaries as it is, living hand-to-mouth, what happens if rates spike? If they don’t have the financial discipline to live as though rates were higher, and save the difference in good times, will they really (as they tell themselves they can) be able to tighten their belts and avoid foreclosure when rates really are higher? As you can see with the mortgage calculator, it doesn’t take very much change in rates at all to really affect the monthly payments you have to make. If it looks like things might get bad if we return to the ~6% rates of this decade, what about going to the 8% average rate of the last 20 years? Or spiking above 10% like in the 80’s and early 90’s? [At 8%, that 35-year mortgage goes from $1540/mo to $2841] Extending the amortization, going from a 25-year mortgage to a 35-year one can also reduce payments, as you can see above (~15%). Having the freedom to refinance into a longer amortization mortgage can be a good safety valve in the case of a temporary spike in interest rates, a problem with your job, etc. However most first-time buyers are going straight for the longest amortization they can get, so their ability to lower monthly payments has already gone straight into higher housing prices (and that price increase is probably permanent, as long as government policy allows for such ridiculously long amortizations).

The last shred of hope is that even though rates can only go up, they can take their sweet time getting there, with the example of Japan used to showcase how rates can be kept low for a very long period of time. However, the Japanese scenario is not likely to play out again here IMHO. There are a few reasons for that:

    Japanese society valued having large cash savings. These deposits were psychologically sticky — the Japanese consumer, despite earning no interest on money sitting around, and having a very easy time of borrowing money, was not much interested in spending to stimulate the economy. Westerners, on the other hand, love their 0% financing car loans/leases, and get fed up with GICs that yield less than 1% after tax and look to deploy their capital elsewhere. Rates don’t have to stay low for nearly as long to have the desired effect of stimulating spending.

    Japan was experiencing a bank crisis, but almost the reverse of what happened in this financial crisis: the banks were not solvent, but had plenty of liquidity, thanks to the savings of the Japanese housewives. The low rates for such a long time was their bank bailout. Because the debt markets can still demand a premium from banks to loan money (while deposits are generally the cheapest form of funding), it doesn’t matter too much to recapitalizing Western banks what the interest rate gets set at, as long as they can make their spread (unlike the Japanese in John Hempton/Bronte Capital’s example, zero rates does not translate into free funding for them).

    There was competition for lending in Japan, squeezing margins. For a while, that was happening in the US, which is part of what brought on the crisis — margins no longer allowed for reasonable loss provisions, let alone profit. In Japan, the lack of a decent margin meant rates had to stay low so that the banks could be cash-flow positive, and they had to stay low for so long because everything was so inter-connected that the banks didn’t want to foreclose on heavy industry borrowers or golf courses that they actually owned themselves. In the US now, the foreclosures have happened, the bubble has burst, the write-downs are taken, and where needed, the taxpayer bailouts have been made. In the west, everyone is eager to borrow, and margins have been getting fatter as the banks use every excuse related to the crisis to hike fees (and also take advantage of the flight to safety to lower the margin paid for deposits, though the opposite happens at banks perceived as being riskier). Once we’re sure the risk of deflation is gone, it’ll back to business as usual.

    Even if the Bank of Canada kept the overnight rate near zero for a long period of time, mortgage rates might still go up, since the bond markets that actually supply the funds to the banks can move independently of the central banks.

The housing market needs rates to stay at zero to stay stable; the banks probably prefer lower rates, but they’ll survive with higher ones. Inflation could loom for the rest of the economy though if rates stay too low for too long, and that is what the BoC is out to control. Low borrowing costs also tend to encourage leverage which leads to bubbles elsewhere…


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