Who Suffers The Most When Interest Rates Rise?
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Do you subscribe to the Wall Street Journal?
Wait, sorry, that sounded like such a douchey thing to say.
It reminds me of the line in American Psycho: “Do you tan? I have a tanning bed at home, you should get one.”
But seriously, for those that do subscribe, the weekend edition was rather telling.
No matter what you know, or don’t know, about inflation, you could take a look at the graph on the front cover of the WSJ that showed a spike on the left side and the right side, with four decades elapsed in between.
U.S. Inflation Hit 8.6% in May
Energy, groceries, shelter costs drive fastest rise in consumer-price index since December 1981
That was the headline of the article.
And for those of us born in August of 1980, there’s not exactly a high-calibre understanding of economics around that time.
I spent a good deal of time this week reading about Paul Volcker, stagflation, and US monetary policy around the time of my birth.
It was humbling, to say the least. I have a degree in business with a minor in economics, but I was in school from 1998 to 2003. It’s been a long, long time since I’ve drawn the intersection of an X-axis and a Y-axis and moved one of those lines up and to the right…
In 1980, inflation in the United States was in the double-digits, peaking at 14.8% in March of 1980.
The previous regime of the US Federal Reserve was trying to combat both recessionary pressures and inflation simultaneously, with interest rates being lowered and raised like a yo-yo, making a mess of the financial markets, consumer expectations and understanding, and the price of goods and services.
When Paul Volcker took over as the Chair of the US Fed, he took a completely different approach.
The prime interest rate was jacked up, over and over, spiking at an astonishing 21.5% in 1981.
This causes not just a recession, but rather two recessions, in what’s referred to as the “double-dip.”
But inflation dipped below 4% by 1983, and in the nearly four decades since then, debate has raged about the effectiveness of Paul Volcker’s drastic actions.
For those of you that either have no knowledge or interest in economic history, or are too young to be familiar with monetery policies from nearly a half-century ago, you might wonder why there’s so much talk of “inflation” in the media, or specifically as it intersects with the real estate market.
Historically, the best way to combat inflation is to raise interest rates.
That’s what we’ve talked about on TRB throughout 2022, and after three successive interest rate increases here in Canada, we’re all eagerly awaiting the next inflation figures from Statistics Canada to see if there’s been any immediate effect.
As a refresher, let’s look at the rate of inflation over the last decade:
You don’t need to know anything about inflation to see that something is amiss in this chart.
We are a ways away from the 14.8% peak rate of inflation that the United States experienced in the 1980’s, but the 6.8% mark that we saw in April of 2022 was a big enough concern for the federal government to start acting.
Now, not everybody is happy with these actions.
Get accustomed to seeing articles like this in the paper with regularity:
“Ottawa’s Anti-Inflation Plan Offers Nothing To Struggling New Canadians”
The Globe & Mail
It’s impossible to satisfy every individual, every industry, and every market segment and/or participant.
But the government is going to undo their recent changes; the only question that remains is when they’ll stop.
So what was it like “back in my day,” as some of our parents would say, when interest rates were sky-high?
My father tells me about owning an investment property in Leslieville when he was paying 18% interest.
The property cost him $42,000.
Let’s assume that he made a 20% down payment, or $8,400, and financed the remaining $33,600.
The monthly payments, on a 25-year amortization, were “only” $492.70.
But of that $492.70 monthly payment, how much, on average in the first year, was principal being paid down?
$7.
And how much was interest?
$486.
You’ve heard of the “interest-only mortgage,” right? Well, this isn’t it, although it sure seems that way!
The ironic part is, this house was leased for $900 per month. So despite an 18% interest rate, the investment was actually cash-flow positive, and by a lot!
So there’s your “1980’s high interest-rate horror story.”
Our parents all have them. At least, parents who are of that vintage. For those TRB readers in their 60’s and 70’s, you have first-hand stories yourselves! Feel free to share in the comments below, just for fun…
But with that history lesson on inflation and high interest-rates out of the way, I wanted to look at three hypothetical examples of individuals who own real estate and how they would be affected when interest rates rise…
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1) Woulda, coulda, shoulda…
A lot of folks are in this camp, and many among you might see yourselves in the following example.
Ben was looking at the real estate market in the fall of 2021 but just couldn’t get his act together fast enough.
He’s 26-years-old and works 50-60 hours per week, so what with all those work parties and social commitments in December, he never got serious about his condo purchase until the calendar flipped pages to 2022.
He got his ducks in a row early in the year and had a mortgage pre-approval with a 5-year, fixed rate of 2.79%.
He began 2022 looking at a townhouse that was priced at $699,900, sold for $825,000, and with a 20% down payment, would have cost him $3,052.74 per month on a 25-year amortization.
The problem is: the next unit in that complex sold for $900,000 only six weeks later! To buy that unit, he’d have needed at $180,000 down payment instead of the $165,000 down payment on the previous unit that sold for $825,000, but then he’d also be paying a higher monthly payment at $3,330.26.
When the next unit came out in mid-March, he made a competitive bid at $915,000, which was more than the previous sale, but lost to a bid of $950,000.
At $950,000, his monthly payment would have been $3,515.28, which is a $462.54 more than he would have been paying if he bought the first unit at $825,000.
Ben went away on a trip in April and when he came back, he focused on work for a little while and then got back to browsing new listings. But nothing of interest came out.
In the meantime, his mortgage pre-approval expired!
With the massive increase in interest rates, he is now looking at a five-year, fixed-rate mortgage of 5.19%.
To buy that $950,000 condo townhouse would now cost him $4,502.76 per month.
That’s almost $1,500 per month more than he woulda, coulda, shoulda paid for his monthly mortgage if he’d bought that first townhouse in January!
Imagine that? Higher interest rates lead to higher payments? Egad!
But wait a moment – didn’t the market pull back a little bit since March? Should he be using that $950,000 sale in March as an estimate of what he’d expect to pay today?
That model sold for $825,000 in January, $900,000 in February, and $950,000 in March. Let’s assume that if the same model came out today, he’d expect to pay $875,000 for it.
With a 5.19% interest rate, that’s a monthly payment of $4,147.28.
So it’s still way more than the 2.79% rate for an $825,000 purchase would have resulted in back in January, but it’s not as bad as the $4,502.76 we calculated above.
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2) A new day, a new dawn, and a new mortgage reality…
Alex and Carrie were living in a 1-bed, 1-bath condo when the pandemic hit in early-2020, and like most folks who were forced to work from home, they outgrew the condo very quickly!
They started to look for a house in June of 2020 once the proverbial real estate dust had settled, and they secured a purchase with a closing date in July.
They bought a beautiful semi-detached house in the midtown area for $1,385,000 and, thanks to the equity from their condo sale, they made a 25% down payment.
But more importantly, they are the “face to the name” with respect to those dirt-cheap mortgages you’ve heard about! The legend of the 1.49% mortgage can’t be true, can it?
But it is!
Because Alex and Carrie are living proof!
They didn’t take the five-year like most people but rather the three-year.
Their monthly payment was $4,147.21, which is a joke for the two of them, based on their income. Easy-peasy.
The incredible part is: they’re paying down an average of $2,881 per month in mortgage principal in their first year! So while they pay the bank $49,767 in mortgage payments, an amazing $34,572 of that is “forced savings” since it pays down principal and goes right back into their pockets!
Time flies when you’re having fun! Alex and Carrie sailed through the rest of 2020 and into 2021, they got pregnant, had a baby in early-2022, and they’re absolutely loving the house.
Carrie is on maternity leave and is getting paid, but not to the same effect as when she was working full time.
Summer is coming up and they’re making a travel budget, but Alex realizes that they’re about one year away from renewing their mortgage.
Over three years, they’ve paid down $105,274 in mortgage principal, so together with their 25% down payment on the $1,385,000 purchase, they ‘only’ need to finance $933,476 when the mortgage renews.
But long gone are those days of 1.49% rates.
Today, a 5.29% interest rate would shoot their monthly payment up to $5,584.27.
And worse is that making $67,011 in payments per year would only see $18,608 in principal paid down.
A lot changes in three years! And I don’t just mean how much less cool Alex and Carrie are now that they’re home wiping up baby puke on a Saturday night…
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3) Father knows best!
In the summer of 2018, Roger decided that it was simply time.
His family was going to make the move.
They had lived in their own definition of “squalor” for far too long. That sad, little, 3-bedroom house with the mutual driveway that would barely allow for Roger’s leased Porsche to fit on their illegal front parking pad.
One day, Roger called his wife, Evelyn, and told her to meet him out front of the house.
He pulled up, told her to hop in, and then drove to midtown where he pulled up in front of a house with a “FOR SALE” sign on the lawn.
He smiled at Evelyn, said “Welcome home,” and they went inside and fell in love. First, with the house. But then with each other – again, because expensive things make people happy.
They pulled the trigger on this $4,250,000 home and Roger went to work on how to finance it.
Roger is brilliant, in his own mind. He figured that he would take advantage of the 2.49%, four-year, fixed-rate mortgages being offered, and make the smallest down payment possible so that he could keep his cash to invest in crypto and tech stocks.
Amazingly, they were able to buy this house with only 30% down!
The land transfer tax of $182,450 was tough to swallow, but they should just shut the $*!@$& up about it because society has determined that people of means should be continuously held upside down and shaken until every last penny falls out of their pockets.
Their monthly mortgage was a whopping $13,460.70!
But that’s no matter for Roger, since only $6,303 of that was “lost” in the form of interest. That was a pittance to be able to live in this awesome house!
Four years flew by, Roger lost some hair (but that could have been due to the wind in his speedboat…), Evelyn played a ton of tennis at the club with her private teacher Colby, and nobody really paid any attention to the kids…
Roger went to renew his mortgage in the summer of 2022, having paid down $357,262 of principal over for years, and now owing $2,754,587 on the house.
Rates increased even further in the summer, and the best he could get was a 5.49% rate over five years, which he wanted to take this time because he regretted only taking four years in 2018.
His payment was now going to rise to $15,963.22.
I wonder what was going to hurt Roger more: paying $2,500 per month more in mortgage payments, or having bought all that stock in Robinhood Markets back in the summer of 2021…
Alright, so which of these three situations is the worst?
In the first situation, you see an extreme case of buyer remorse. But can we feel bad for Ben for not having pulled the trigger in an environment of low interest rates, before a real estate price spike, in the same way that we’d feel bad for somebody who didn’t short-sell the Nasdaq on New Year’s Day?
A market is a market. What type of market need not matter.
Market risk, losses, gains, actions, and inactions are all the same, no matter the market.
Yes, it’s going to cost Ben more money each month if he still wants to own real estate, but whether or not Ben can afford those payments is a separate issue.
In the second example, we see what happens when a person or a couple’s income changes.
People switch jobs, they make more or less money, some go work for a start-up that has long-term earning power but puts stress on short-term cash flow, and then some people take time off to have babies! There are countless examples of how the ability to make mortgage payments can change.
But will the increase from $4,147.21 to $5,584.27 force this couple to sell their house?
No. Of course not.
And what I didn’t discuss above, simply for effect, is that not everybody has to run and take a five-year, fixed-rate mortgage just because rates have increased.
In fact, Alex and Carrie could simply take a variable rate, currently about 3.25% for a conventional mortgage, and their payment would only be $4,538.24.
So they’re paying $400 per month more, not $1,400.
People do have options out there.
The current spread between variable rates and fixed rates is massive, and although the variable rate will increase in July when the Bank of Canada raises overnight lending rates again, there’s still a significant discount over a traditional five-year-fixed.
In our last example, no matter how douchey I try to make Roger sound, he’s still going to have no problem paying $15K per month instead of $13K per month. The bigger issue is how much money people have lost in the stock market so far in 2022 and how that could affect their ability to make those payments if they’re drawing on cash reserves.
Call me biased here, but an increase in interest rates is not going to kill our real estate market.
What’s actually responsible for the recent drop in real estate prices, sales, and activity is buyer psychology.
Sure, there’s a buyer out there who’s margins were so thin that he could afford a $2,100 per month payment but can’t afford $2,300.
But as demonstrated above, increased payments aren’t going to force people to sell their houses and live in tents.
It’s change, mixed with confusion and uncertainty, plus a healthy dose of fear, that’s caused the market to retract up to this point, and while the coming increase rate increases are going to affect affordability, it’s not as dire as some bears are making it out to be.
We’re not going to 21%, folks. We’re not even going to 6%. And while that probably opens a conversation about interest rate predictions, and I’m happy to have one, I’m more interested in when, where, who, and how a hypothetical property owner gets steamrolled by a 3.25% variable rate. Go on, try me…
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