Friday, May 18, 2007

What happens when interest rates go up?

I thought I'd play with some potential scenarios today. I'm using some-what arbitrary numbers to run these scenarios. Here's a list of the assumptions:
  1. Mortgage is amortized over 30 years. Why 30? Because I think its probably the median of what is being sold to many people these days.
  2. SFH price will be $500K, simply because it is an easy number and just about the median price of SFHs here now.
  3. Family income is $72K. This isn't the average, nor the median, but it is near both. It's an easy number to break down into monthly terms for this exercise.
  4. Down payment will be 10%. I have no idea how to find out what the average down payment is these days, but I'm guessing this may be close.
Scenario One: Today

House purchased at $500K using interest rate posted by Big 5 bank, I've assumed a negotiated discount from 5.85% to 5.25%.


Those are big numbers. Our pre-tax income is $6000/month. If we pay bi-weekly, we are using 38% of our pre-tax income to service our mortgage debt. Let's factor in other housing-related costs of $2200 in property tax. I'm using this number because it is the actual, after-grant charge of a friend of mine who lives in Saanich and owns a home that fits these assumptions, anecdotal I know. We'll use the widely-accepted 1% maintenance theory, which equals $5000/year. So in addition to our $2280/month we have $420/month in maintenance and $185 in taxes for $2885 or 48% of our pre-tax income going to our monthly housing ownership costs.

Scenario Two: Five years down the road

We need to renew our mortgage. Interest rates are back closer to their historical norm of 7.5%. Let's see what's happened:

First off, we've built up some equity. About $35K of the approximately $150K we've given the bank so far has gone to principle. But, the interest rate has gone up and now we have to pay more to stay in the same place. Our incomes went up, with inflation, so our $6K/month is now $6500/month. Again we'll pay bi-weekly. $2800 to the bank. We'll assume that taxes stayed the same as did maintenance, so our costs are $3400/month. What's that in percentage: 52%. Surprisingly, that's only a 4% increase in costs, despite a 2.25% jump in interest rate.

What's the point of all this? Merely just messing with some numbers arbitrarily. Is it likely that these scenarios will take place? Who knows. But it makes me wonder if interest rate hikes really matter all that much? Over to you.

7 comments:

greg said...

Run the same scenario with earnings of $4000 per month, and a crappy $220,000 condo, with similar expenses, plus a strata fee, plus an assessment of $20,000 for new balconies, hmmm. These types of scenarios are potentially ugly, every situation is different....

hhv said...

greg, you may have noticed my emphasis on pre-tax income. Looking at those numbers using after tax income (say we pay 29% tax) doesn't leave much of anything left over for anything.

No wonder why everyone needs a secondary suite.

Mr. Mookie said...

Interesting...

You've worked numbers that are pretty close to the house that i live in. I rent for 950/mo, utilities included, for about 60% of the total square footage. This place is suited and and the person downstairs pays 800. The house is up for sale for 464k. I know that i pay below market rent, however an un-suited house this size typically goes for around the same price and less rent-wise for this neighbourhood.

So... rent vs buy for a similar place is a no-brianer at this point in time for me. Total rent is $1750 (3bed, two bath), no utilities, no maintenance, no taxes, no playing the landlord, and no surprises (interest rate rise, busted furnace, etc). Oh except the landlords decision to sell, THAT was a nasty surprise!

I have a plasma TV hooked up to my computer that plays gay bareback porn everytime there is a showing (with the sound down so the prospective buyers can still hear the traffic on Cook) and I've got the *biggest* box of rat poison on the kitchen counter you ever did see. Wonder if that is why the place hasn't sold yet?

Anonymous said...

mr mookie that was a nasty one, lol.

Anonymous said...

mr. mookie

Your place just hasn't found the right retired oil barron from Alberta yet. Just you wait. With all the retired people coming here in droves and prices continuing to go up and no more land being made you can only hold out for so long. They'll probably be bidding wars on it too gay porn notwithstanding.

S2

Anonymous said...

Pretty good scenario. So if my understanding is correct. In five years with mortgage paydown and an increase in your income, your disposable income is less than when your bought the property. Which, in my way of understanding is a drop in your standard of living? Of course, you could sell the property, but that 35K in mortgage paydown would be gobbled up in the agents commission and mortgage penalties. During this five years, the 150K, that you paid to the bank equates to $2,500 per month less your mortage paydown would be $1,916 or roughly the same as rent. BUT, hold on if you had rented, you would not have paid $11,000 in property taxes, purchase tax, lawyers fees, etc.

The return on your down payment would actually be negative. Looking at lost opportunity costs. If your down payment had stayed in tax sheltered mutal funds at 7% you would have been better off and closer to having an income stream for your retirement.

Now, I am assuming that the property values stayed flat. But, that would probably not be the case. The prospective buyer for your hypothetical home would have to finance at the new rate. For every 1% increase in the interest rates, property values have to decrease by 10% to retain the same monthly payment.

It just gets uglier and uglier and uglier.

Siobhan

Anonymous said...

Mr Mookie,
It's going to backfire on you. A gay-porn-lover who likes having pet rats will walk into your place and buy it for over-listing price with no conditions.