The first example is the early 1980s, when after sharp real estate price gains in the late 1970s we saw interest rates skyrocket in 1981 and 1982, causing many people who had their mortgage come due to default on their homes. Real estate prices dropped between 25% and 50% across BC communities as many homes went into foreclosure. People often tell me this example is pointless as we will never see these interest rates again. So let’s focus on something that is comparable and that is how much in percentage terms an average family’s mortgage payments rose when they renewed their mortgages.
The second example is the recent US housing implosion where home buyers were sold adjustable rate mortgages (ARM) which had teaser interest rates for the first two or three years and then rose to “market” rates thereafter. LIBOR rates to which these ARMs were tied increased as we moved into 2007 and 2008 so when the interest rates reset on these mortgages (sub-prime and non sub-prime) not only did the teaser discount go way, but the base rate had risen causing a massive jump in mortgage payments. The result has been massive mortgage defaults both for sub-prime and non sub-prime mortgages. House prices in markets where these ARMs were common have dropped as much as 50% and some feel the bottom still has not been reached.
The table below compares the average mortgage payments at the initiation of the mortgage (1977 for BC and 2004 for US) versus the reset cost (1982 for BC and 2007 for US).
Considering the high level of inflation in the late 1970s and early 1980s, we can discount the 48% increase in the BC example conservatively to 40% to be more comparable to today’s lower inflation levels. This analysis demonstrates two real examples when mortgage payments rose by 40% the real estate market collapsed.
A mortgage broker I spoke to recently told me with these low interest rates far more people are renewing or renegotiating mortgages today than they are selling mortgages for new home purchases. Combine this with the fact that the BoC plans to keep interest rates low over the next year, I expect there will be at least 20,000 mortgages in Greater Victoria being placed at these low levels before rates start to rise. But what happens when interest rate do rise? The chart below takes a 3.75% five year mortgage today with a 35 year amortization and assumes a reset at varying interest rates in 2014 to determine how much payments will rise relative to today’s cost.
What this chart tells me is that if interest rates rise to 7% or higher over the next five years there is a high likelihood we will see a serious real estate price correction and prices could correct by 30% to 50%. If interest rates rise say to 6.0%, which is where I would forecast assuming we achieve a “soft landing” as Alan Greenspan would define, then we are in the danger zone. In this danger zone a large number of home owners will be in trouble when they renew, but it will not be widespread across the market. In this case price reductions will likely be dictated by how many willing and able buyers there are relative to defaulting homeowners.
ABOVE POST BY REID