Low-down-payment deal can backfire when interest rises.
The real estate industry’s exuberance is much in evidence. The Business Edge is no exception. This issue abounds with forecasts and reasons why people should acquire the affliction of being lords and ladies of the manor.
But we are fast approaching a “tipping point” that requires careful reflection of the basic economics of such a significant acquisition.
At the end of 2003, the average home price in Vancouver was $329,447. In Calgary, it was running at approximately $215,000 in the third quarter. Peter Norman, a vice-president of Toronto’s Clayton Research, recently commented that new home construction hit a fevered pitch in 2003. New housing starts climbed to a level not seen in 15 years. The trend is clearly up!
Most purchasers are first-time homebuyers enticed by the little- or no-money-down mortgage offered by innovative lending institutions. My concern is for these folks.
These historical highs in the selling price of homes are possible because of the historical lows in mortgage rates. Recall inflation rates in Canada are in the range of one to two percent. Currently, a closed six-month mortgage can be obtained at a rate of approximately four percent. Buyers do not decide to buy solely on the purchase price of the home; but instead, they place great weight on the amount of the mortgage payment that they can fit within their monthly income.
A four-and-a-half-per-cent short-term mortgage of $200,000 requires a $1,260 mortgage payment. Having lived through the ’80s, I believe an eight percent mortgage would be closer to the long-term rate one could reasonably expect. At this rate, the mortgage payment would increase to $1,656:An increase of $400 a month!
Compounding this problem is property-tax assessments. The Capital Region in Victoria sent out assessment notices in the past few weeks. Homeowners were shocked to learn that an average of 16 percent increased their estimates. Based on last year’s tax bill of $2,500, this represents a further $400 cost of homeownership.
These demands on the family paycheque were not budgeted for when the “little-or no-down-payment” obligation was entered into. The results can be devastating, particularly for younger folks who bought into the dream.
It is going to get even more troubling. The federal government announced that in 2004, all levels of government will experience a “big fiscal squeeze” and that Canadians should not count on government largesse for the next few years. Not welcome news because all provinces, except Alberta, are running a deficit or close to a deficit in this year’s budget.
According to CIBC World Markets, the projected budget shortfalls will increase from $1.7 billion last year to $8.1 billion in 2004. The National Associations of Municipalities have just met with Prime Minister Paul Martin and expressed their vital concern that municipalities in Canada do not have sufficient funds to maintain current service levels. It seems that higher levels of taxation and user fees are unavoidable.
These provincial deficits are partly due to the economic slowdown in Canada, which is a meagre 1.6 percent. This is significantly lower than our politicians touted only a few months ago. The result? Watch for announcements that transfer payments to British Columbia and other “have-not” provinces will be reduced this spring, thereby compounding the problem for homeowners and others.
As already mentioned, historical highs in the purchase price of homes are driven in considerable measure by historical lows in interest rates. And yet another Home Economics 101 consideration: As the interest rates move higher towards eight percent, the value of homes will drop. They will settle for the same reasons that they rose: Purchasers apply the test of “affordability” rather than genuinely evaluating the home’s selling price.
Higher rates mean they can afford less in monthly payments.
But of more significant concern is the home owner’s equity. Any minimal down payment vanishes as the selling price of the home cascades, likely to levels less than the face value of the mortgage. The ripple effect of this through the lives, the community and the lending institutions can be dramatic.
Of interest to Western Canada and Alberta, in particular, is the economic health of beef producers. As a result of the last round of mad cow disease, Albertans lost more than $2 billion off the bottom line – and with the current American protectionist attitude, this damper to our western economy is likely to continue. If the resolution is not quickly forthcoming, this event will contribute to the housing market’s pending storm.
A further economic blow is emerging due to the potential easing of crude oil prices during the current year. This will also affect the real estate market. Watch this column for more on this concern shortly.
So a warning to new first-time homebuyers: Although I believe the clouds are nine months out, I would not bask for long in the glory of the affordability of the new manor but rather, prepare to mitigate the potential damage that homeownership may inflict if interest rates start an upward trend by year’s end.
Note: This article was originally published in 2005.
