June 9, 2017

Canadian Housing: "...but Rates are Far From from Previous Peaks of 5 or 6%"

Many misinterpret the gap between today’s low interest rates and historical interest rates as some kind of buffer against financial stress, particularly with respect to housing. The reality is that the absolute level of interest rates is less relevant than relative changes in the interest rate.

For example, if you have a mortgage rate of 3% a 20% rise in rates would increase your mortgage rate to 3.6%. Initially, this sounds like a tiny increase. However, it remains a 20% increase in interest expenditures, affecting monthly household cash flows.

It gets worse though.

What people forget is that with low interest rates comes extra borrowing. Suddenly everything becomes affordable so people buy more – bigger houses, better cars, etc. According to this:

“When economic entities (people and businesses) borrow they don't necessarily first consider the impact to their balance sheet. Their primary concern is servicing the debt when payments are due. They look at debt servicing capacity as a budget that can be allocated to borrowing. Consequently, when the cost of servicing debt declines entities don't necessarily re-allocate their freed-up cash flow to other business or personal needs. Instead, they tend to borrow more to spend their entire debt servicing budget (e.g. to buy a bigger house).”

The result is that families are more exposed to a 20% increase in rates when rates are low than they are when rates are high.

I recommend reading this article in full: Ultra-Low Starting Point Makes This Rising Rate Period Worse

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