interest rates – Money Smarts Blog

This post is part of a group writing project with the M-Network bloggers and friends. See the list of other posts in this project at the bottom of the post.

There has been a lot publicity around the subprime mortgage situation in the US. There are quite a few homeowners who have been or are about to be evicted from their houses because of a number of different factors. ARMs, NINJA loan, liar loans, fraudulent lending practices and worst of all…easy credit and low interest rates led to a situation where real estate prices went up and up. People who took the plunge five years ago with flipping houses made so much money that everyone wanted to get in on it. Now that the real estate prices are not going up anymore, the gravy train has stopped cold.

In Canada, we haven’t seen this situation (yet) and I think there are several reasons for this:

Real estate prices haven’t gone up as much as in the US.
Lending practices in Canada were stricter than in the US.
Interest rates are stable.
The economy is still going strong.

Real estate prices

Real estate prices did not rise as much in Canada as they have in the US over the last several years which might have helped prevent mass speculation. It’s easier to get excited about property investing/flipping when you see 30% annual returns compared to 10% returns which is roughly what we saw here in Toronto. I believe that people who are flipping properties are more likely to use excessive leverage in order to make more money. This works really well as long as the house goes up in value but if the house goes down (which is happening in the US) then the flipper might be in big trouble.

Stricter Lending Practices

The use of the word “stricter” is this case is a relative one. The last few years have seen changes in the mortgage market in Canada where you can buy a house with zero down, get a no interest mortgage and for those who are inclined to pay a smattering of interest there are 40 year amortization terms available. All of these features allow the Canadian home owner to increase the amount they borrow which will increase the odds of problems if any of the above factors come into play.

In the US it appears that anyone with a pulse and no paperwork or job or money could get a mortgage which obviously increases the odds that some of those borrowers won’t be able to make their payments. The availability of ARMs (Adjustable Rate Mortgages) is another product which can be very useful for some home owners but for some borrowers they were a way to get a house (for a few years at least) that they couldn’t afford. It was just recently that the US government passed legislation that makes lenders consider the payment after the mortgage reset (and not during the teaser rate period) when they look at the repayment ability of the borrower. Hard to believe that sort of common sense rule has to be legislated.

Interest Rates

This is another factor that applies to both Canada and the United States. While interest rates are higher than a couple of years ago, they are still fairly reasonable. If rates were to go up say 2% then I think that this will expose some sub-prime borrowers because they might not have any room to cut back in their budget to pay for a few more hundred dollars of interest each month. A borrower with a better credit rating would also feel the pinch with higher interest rates but they would likely have more flexibility in their budget.

Economy

The economy and job situation is still quite good in Canada which is not really different than the US but if we see a recession in either country and unemployment goes up, then that will certainly put more pressure on highly-leveraged home owners and foreclosure rates will go up.

Summary

Loose lending standards and rapidly increasing real estate values were the main reasons that led to some American borrowers taking out speculative mortgages that they couldn’t afford. Because these factors were not as prevalent in Canada I think that there are a lot less borrowers in Canada who are on the edge as far as being able to afford their mortgages. That said, lenders in Canada will still give borrowers a lot of mortgage which some people have taken advantage of, so if unemployment goes up and/or interest rates go up, we could still see a smaller version of the sub-prime mortgage crisis here in Canada.

The Globe and Mail recently had an excellent article ( free login required ) on subprime lending and some of the fraudulent sales methods used.

Finally I will leave you with link to a sub-prime mortgage discussion written by a senior employee at Pimco – it’s very informative and the format (the economist is talking with his pet rabbit) is very entertaining while at the same time, somewhat disturbing. 🙂

Other posts in this series

My Two Dollars posted My Thoughts On This Whole Mortgage Crisis And Why I Don’t Feel That Bad. This excellent post explains why David is a bit annoyed that people who overbought are getting helped by the government while fiscally responsible people (like him) don’t get anything.

Finance Freelance Life explains how renting a home and buying a home are not as different as they seem in Why renting is right for us right now.

Rocket Finance has a great post about his own real estate mistakes.

My Dollar Plan (yes, the one with 181 financial accounts) tells us a very unusual story of how she has an adjustable rate mortgage (ARM) and not only is she happy with it – she doesn’t blame her mortgage broker, the government or space aliens for the fact that she has one.

Moolanomy explains Debt-To-Income Ratio and Why It Matters. This post covers why you shouldn’t spend too much of your net income on your house.

Millionaire Money Habits tries to decide between investing in stocks or real estate in Catch a Falling Knife – Buying the Housing Slump.

PaidTwice wrote an interesting post on the “Can we afford it” mentality which gets into the problem of people deciding if they can afford something (such as a house) based entirely on the monthly payments.

Debt Free Revolution talks about how maybe it’s not such a good idea to take advantage of increased equity in your house by paying off credits cards with a HELOC. (Home equity line of credit).

Remodeling This Life wrote a post about how she and her husband bought a house and totally gutted it. This post brought bad some unpleasant memories for me because of our own fixer-upper experience. She has a fair bit of advice and warnings for anyone who wants to buy a fixer upper.

Being Frugal wrote Frugal Hacks For Your Home. Still not sure exactly what a “hack” is but maybe this post will tell me….

Plonkee Money asks why anyone outside the US should care about the subprime mortgage crisis.

Cash Money Life explains how mortgage escrow accounts work. These are more common in the US although I have heard of house insurance payments being combined with mortgage payments. In a related article he discusses how his mortgage payment dropped recently because of changes in the escrow liability amounts.

Single Guy Money talks about the real cost of home ownership.

This is the third post in the “Leveraged Investments” series. Check out the previous post entitled “Leveraged Investments – The Risks”.

My biggest concern with doing leveraged investments since I have a large mortgage is interest rate exposure with respect to cash flow. In my opinion, nobody “needs” to do leveraged investing including myself which is why it is important to understand and minimize the risks. However I find the idea of it rather enjoyable and believe that I can make a profit out of it. Although I’m fully aware that the investment plan may not work out (won’t be the first time) I don’t want it to negatively affect my personal cash flow to the point where I regret doing the plan. This will mean limiting the borrowing to fairly modest amounts (compared to say the Smith Maneuver) which will limit any potential profit but it will also limit my exposure in case things go south.

I outlined in my last post most if not all of the ways that the plan could fail, however my biggest concern is interest rates since if they go up, the cash flow for the plan will go more negative and that’s not a good thing if it’s taking money from other activities that I like to do.

My assumptions for the interest rate calculations are extremely conservative and I wouldn’t think any less of someone who didn’t adhere to the same level of stringency.

My calculations:

In my mind, to calculate your interest rate exposure properly you should include all your debt so I will include my mortgage & investment loan.

Currently I’m paying $1500 / month on my mortgage. This amount is a bit much which is why we are lowering our monthly payment but we can get by ok on this amount if necessary. Regardless of what happens with the leveraged investments or interest rates, I don’t want to have to pay more than $1500 / month to cover my total debt payments

We have recently locked in our mortgage for a five year term which is important in this calculation because it is not the current amount of the mortgage that is at risk if interest rates change, but rather the portion which will still be outstanding at the time that the locked in period ends. In our case I estimate that once the five year period ends, we will owe $110,000 on our mortgage.

I’ve assumed a worst case rate of 15% interest – feel free to pick your own poison. I’ve also assumed my stocks have completely stopped paying dividends. Like I said, my safety test is stringent! I have however assumed that the tax rebate is intact and that my tax bracket is unchanged.

One more thing – I’ve stated that the current monthly maximum loan payment I am willing to handle is $1500. In five years at 2.5% inflation, that amount will be $1700.

Ok, to start off – I will owe $110k on my mortgage in five years and the interest rate is 15%, so the monthly payments will be $1447 – less than the $1700 maximum so there is room to borrow. In this case I’m amortizing over 25 years.

To add the investment interest payment to the calculation I have to account for the tax rebate, so for every dollar of investment interest, I’m only responsible for 56% of that amount. In other words I have to add 56% of the investment loan to the mortgage amount.

After playing with the numbers, if I have a $110k mortgage and a $40k investment loan then the monthly payment will be $1700 ($1500 in 2007 dollars) at 15% interest. So from that, $40k is the maximum amount I can borrow for investments.

Needless to say, this type of calculation has to be kept up to date since any changes in the rate of mortgage payments or any new debts will affect the amount available to invest.

The other limiting factor is the effect on your current cash flow from borrowing. If you were to borrow $100k at 6% and start a plan like this on January 1, your spreadsheet might tell you that your net cost per month is only $79 per month, however you might not get any dividend cheques for a few months and you won’t get the tax rebate for over a year so you need to be able to handle the gross interest payment ($500) for at least a little while. This is why I have only started the plan with $7100 so far and will be taking my time to get up to the $40k limit (if I get there at all).

Anyways, not sure how clear that is but feel free to ask questions or offer comments or criticisms!

The next post in the series is “Exit Strategies”.