Do low interest rates help or hurt?

Low interest rate reduce carrying costs during the initial mortgage term and saves the borrower some amount of money. One concern is the effect of the low interest rate of the purchase price itself, potentially reducing or even reversing the benefit of the initial rate. This post will take a look at a hypothetical condo purchase in Edmonton and the amount saved on interest rates and/or lost due to inflated valuations.

Low interest rate purchase

Consider a 891 sq. ft, 2 bed / 2 bath condo in South Edmonton suburb of Ellerslie. The asking price is $199,000.


With $19,900 down the initial mortgage balance is $179,100. The mortgage is as follows assuming a 5-year fixed rate of 4.10% and 25 year amortization.

2009 Purchase price: $199,000
Down payment: $19,900
Initial balance: $179,100
Rate: 4.1%
Monthly payments: $951.84
2014 Balance: $156,184

Rent for two years and purchase with higher rates

Compare this to waiting for two years and taking out a 5-year fixed at 7.10% at three different prices. One will be a market crash of 30%, one only 10% and another with zero appreciation. In each of these cases there will be some gain on the down payment and some difference between the cost of renting and owning.

If we expect to use this down payment in 2 years its not going to be put at huge risk. Lets go with 3%. After two years the down payment grows to $21,112

Even with these low interest rates there is a small premium to own. First assume this apartment rents for $1200 including utilities. An owner will need to add $270 for condo fees, $50 for power and $120 taxes. So the monthly savings renting is ($952+$270+$50+$120)-$1200 = $192. After two years that adds up to $4,608. So total down payment is $25,720 after two years in each of the wait cases.

Wait case #1: 30% decrease

After a brutal decline the purchase price of an equivalent condo decreases to $139,930. I am comparing the balance after 3 years to have this case line up in time with the one that bought immediately. The mortgage terms are as follows:

2011 Purchase price: $139,930
Down Payment: $25,720
Initial balance: $114,210
Rate: 7.1%
Monthly payments: $807.01
2014 Balance: $108,578

This case shows that low interest rates are not enough to offset a market crash (duh!). Not even close as both monthly payments for the initial term and final mortgage balance after 5 years have elapsed are lower. Amount lost on difference in monthly payments over three years is $5,213 and the difference in mortgage balance is an additional $47,606. Total lost buying with low interest rates before a 30% crash: $52,819.

Wait case #2: 10% decline

The purchase price of an equivalent condo is $179,100 with the following mortgage terms:

2011 Purchase Price: $179,100
Down Payment: $25,720
Initial balance: $153,380
Rate: 7.1%
Monthly payments: $1083.79
2014 Balance: $145,816

In this case the reduction in payments with low interest rates($4,750) is not enough to offset the higher mortgage balance at the end of the term (-$10,368). Total lost buying with low interest rates before a 10% correction:$5,618.

Wait case #3: No appreciation

The purchase price of an equivalent house remains at $199,000 with the following mortgage terms:

2011 Purchase Price: $199,000
Down Payment: $25,720
Initial Balance: $173,280
Rate: 7.1%
Monthly payment: $1224.40
2014 Balance: $164,735

This case shows in absence of any price decline, the amount low interest rates benefit the original purchaser. The amount save on payments due to low interest rates for the three years the mortgage terms overlap is $9,812 and the balance is $8,551 less. Total gained by buying with low interest rates $18,363.

Low interest rates save the buyers money if we assume no, or only a minor market correction once rates increase.

Hit Piece

This post highlights some examples of misinformation from the blogosphere, some going back some time, to show that it is important to be able to verify information... Well actually it's just a hit piece, but those get all the attention so here it is.

Take a look at this blog exchange from Bob Truman's blog from March 2008, archived here. This is not about Bob, but Mike from the comments.

On bears:

There will always be people who say "homes are unaffordable", or make up a vault of excuses not to try to buy one "they will go down... it's better to rent... I didn't buy at the ""right time"" etc".

On getting into the market (in March 2008):

With 40 year mortgages, and 5% down, you CAN get in, work hard, save hard and that home ownership dream is yours. The ney-sayers will say "40 year mortgage, forget it", "5% down? CMHC fees are too much!!". If you start with a 40 year mortgage remember it doesn't mean you have to wait 40 years to pay it off.

Advice to a renter saving up for a down payment:

Tips. I eat noname Mr. Noodles for lunch daily, my wife makes and packs her lunch daily. We go out to eat 2 times a month but spend $20 on a meal for 2 (Entertainment Guide). Walk or transit all we can. Buy gas at discount stations only. Drive an economical car (Aveo). Use energy eff lights, have the heat set lower, etc. It all adds up. :)

Buy vs. rent

(note the below example is very rough, but its a good "general" example)

EG; Take a $350,000 mortgage, 25 year, fixed at 6%. Payed Monthly.

You take 25 years to pay it off. You'd pay $321,800 in just INTEREST. In 25 years, that $400,000 home would be worth, say, $1.5 million. So you net out $778,200 at the end of the day. That's a good investment, honestly. You made $778,200 TAX FREE baby!

Take the same $350,000 mortgage, 25 year, fixed at 6%. BUT payed Weekly and DOUBLE your payments.

You'd pay $89,514 in just INTEREST. In 8 years (you just chopped off 17 years in payments too). Sell your home for $1.5 million in 25 years (you did live mortgage free 17 years of them too).

You made $1,010,485 TAX FREE baby, Oh ya! Sign me up!

The best part is not only did you pay LESS in total buy paying MORE in payments, you also made $232,285 for your dedication AND lived 17 years with NO MORTGAGE payments.

More buy vs rent and price drops:

For me, If I rent the same home I'm in now, it's $4,000 a month (that's what the smaller home goes for next door to me). And some suggest rent for 36 months then buy... that would be $144,000 in rent. That home is worth $800,000 thus that home would have to lose 18% over 3 years and then you'd "break even" with the renter.

Do I think Calgary RE will go down 18% in 3 years?? Of course not; but even if I said yes, you would still be no better off renting. You could say "your paying 4.6% interest on your mortgage that would make a difference" yup. But on the flip side, I'd wager the rent will easily go up by 4.6% a year too. ($1000 = $1047 next year).

Response after Radley challenges the assumed appreciation of $400,000 to 1.5 million.

It's about an increase of 5% a year for 27 years. 5% isn't much a year. If your making, say $60,000k a year, and your keeping up with inflation of 5%, then in 27 years, you would be making: $224,000 a year and rent would be: $7,500* a month as well. Although we know that rent increases FASTER than both home appreciation and wages, so expect rent to be $10,000 a month. (*based on $2,000/mo rent today). Wow, think how much a renter would throw away in home equity.

Another anecdotal example supposedly representing the market in March 2008.

Well, there is NO information like up-to-the-date accurate, real-life information on what's happening in the market and I can give you some of that now:

Great News!

WE SOLD OUR HOME! WOOHOO. :) (privately, no realtor)

We got multiple COMPETING offers, and sold $130,000 ABOVE our asking price, NO conditions. Sold in 6 days plus the multiple offers and contracts, total took about 2 weeks. (TBS official tomorrow)

So, yes Virginia, there are not only buyers out there, but also money to buy too.

Now, we are in the Calgary market to buy again.

Mike

I challenged the notion of the overbid being representative of the market in general

Mike L,

On Mike's site the highest above list price any SFH in Calgary so far in March is 4%. Most under is 18%. Its more likely that the overbid was a result of the initial asking price, if it occured at all.

His response:

Yes, it indeed occured (I have no reason or desire to lie) and no my initial asking price wasn't low at all; It was fair market value. In fact, if we only had the inital offer we would have accepted it. As its a private sale it won't show up on the MLS or Bob's stats (although Bob, if I give you the stats can you use them?). It was most definately over 4% list. The important thing was starting at an accurate market price.

Another poster Warren posts up even older information regarding this sale

I'm curious about your anecdotal story. Is this the same house you were selling last year? On August 30, 2007, Mike wrote:

"Our home was listed for 5 months, we went from $999k to $825k. We took it off because at $825k we couldn't find a 3,200sq/ft dev, inner-core, blue blood neighbourhood, 50x120' lot, reno'd, solid home with views for that price. Our issue (doesn't all homes have at least one?) is that we are on 17th ave SW, unfortunately I can't move the street.

Will we relist? Yes. Lower? Yes. I was thinking $775-799k. Everything is indeed coming down so if I loose a little on my sale I'm betting I can pick up a home right now for less too. Works out in the wash."

Unless I am mistaken, in less than a year you went from a $999,000 list price to (according to yourself) an asking price of $675,000. Isn't that a reduction of 32.4%?

So even with a 19.5% overbid, you still sold it for 2% less than than you were asking last summer and 20% less than you were asking a year ago? Is this a different house, am I getting the story confused?

More from Warren:

I was going to write this really long review of all the contradictions Mike has made (which year his house was bought; whether it sold for $807,000 or $835,235; his proud claims of a 19.5% overbid after he slashed the asking price 32.4%, etc, etc).

But then I realized it's a waste of my time. RJ laid out excellent rebuttals point and point again to no use. Mike has no concept of the effect of inflation on asset values, or the opportunity cost of money, or the effect of leverage, or any of a dozen other basic principles of finance. Is this why you mock higher education??

There is a lot more in the thread. So what? This is old news. Who cares? I think it is useful because this same poster is now using similar misleading anecdotal examples or observations to represent the current market as a bear. As before these examples are inaccurate, insincere or some combination of both.

Recently Mike has commented on some sales in the Scarboro area in Calgary on the Alberta Bubble Blog.

Wow, look at this, just came up today:

http://www.realtor.ca/propertyDetails.aspx?prop...

That's a $600k purchase 15 months ago plus new kitchen, flooring, bath and paint, now for sale at $339,900.

Who said RE always went up? And considering Calgary CREB is touting "increasing prices"...right! That's 240k lost there.

I knew the 93 year old who sold that house as they were 2 doors down from my old house.

Mike

Notice how this was taken to represent the market more accurately than CREBs numbers. But he didn't mention the lot subdivision and development which played a role in this sale as DaBull points out.

If you look at the titles, from the Spin II system, they actually bought 2 lots with houses for a total of $632K in Dec 2007. They subdivided into 3 lots. Sold the one to the left for $340K, are currently selling the one to right for $339K and either keeping or selling the new empty lot they created in the middle. Made their money back and either have a lot which didn’t cost them anything or are going to sell it for a tidy profit. Not everyone is a stupid as you think they are.

Another example here

$300,000 loss...

http://www.realtor.ca/propertyDetails.aspx?prop...

Sold for $1m 14 months ago.

Who says Calgary RE is going up?

Mike

...

I've been in the house many times before as I knew the renters in there. Nice house, built in 2001, but built very cheaply and "feels small" for it's size. Has had nothing but problems (plumbing mostly). The developers bought it for the land but looks like they are ditching their holdings.

Horrible to backout on 17th ave from the garage as well.

Just goes to show how easy it is to lose $300,000 on a market that, according to CREB, is going up.

Mike

After pointing out the example it turns out the loss (if it existed) is the result of development and subdivision risk and not representative of the general market.

They were assembling a 3 block stretch of land along 17th Ave SW to build brownstones. I am guessing they ran into land zoning issues that could not be resolved (ie. R1 to R1 or RM-4)

17th Ave is not as busy as 14th street and it's the most trendy street in Calgary IMO.

Also he has been "monitoring" some neighborhoods in Calgary and noticed some inventory spikes. Link.

CM asked on Garth’s site, thought I’d post it here to help others as well:

#55 CM “if you’ve seen this marked increase in listings in any other community?”

I follow the true $1m+ communities,

Yes, quite a few like:

Scarboro 10-14 listings, usually 2-4. 500% increase

Eagle Ridge has 4 listings now, they usually only have 1 or 0. A 400% increase.

Bel-aire 4, usually 1 or 2, a 200% increase.

River Park/Elbow Park (south side of river), they have 6, usually 2, 300% increase.

Roxboro, usually 2-3, they have 6. 200% increase.

Mount Royal has 10. Usually 8.

Lakeview Village, 6, usually 3.

Pumphill, 9, usually 4.

Maybe the $1m+ prestige communities are not selling and starters are? Inventory here has never been so high.

Mike F can look into these stats and verify if he likes, I’ve been following these communities closely (almost daily) for 5 years now.

Mike

Mike Fotiou (a different Mike who runs this blog) finds examples of $Million dollar sales that have both made and lost money since October/November

Bob Truman runs some numbers regarding $million dollar sales. Just like in the past market statistics contradict Mike's examples.

The second biggest loser, our buddy Mike(don't get addicted...) maintains inventory is way up in the below listed communities, and that sales MUST be way down, especially for homes over $1 million. Let's look at the facts.

For the six month period Jun 17 - Dec 16, for the communities of Scarboro, Eagle Ridge, Bel Aire, Altadore/River Park, Elbow Park, Roxboro, Mount Royal, Lakeview Village, Pumphill:

	2009	2008	% change
All sales	221	109	+103%
Sales over $1 million	66	41	+61%
New listings	312	376	- 17%
New listings > $1 M	117	154	-24%

.

We can't go back a year to see how many active listings there were, but as you can see, new listings are down, and down substantially for homes over $1 million.

.

I see from the Live Traffic Feed that a person from the United Kingdom logs in periodically, always around 3 a.m. Do you think it could be our friend Mike? Is he still battling his addiction?

Regarding the addiction, Bob is referring to when Mike stated that he doesn't look at his blog because it is "udder crap" then later submitted a comment on it under a different name. I have proof but this post is getting long....

Anyway bull or bear I would not trust anything this guy says.

Klump on interest rates

“Repeating its concern voiced in October, the Bank reiterated the risk that the strong Canadian dollar poses to economic growth,” said CREA Chief Economist Gregory Klump. “They also opened the door to keeping interest rates on hold longer than expected. Low interest rates are likely to continue to fuel home price increases.”

CREA Dec 8, 2009

One thing to note about interest rates is the market impact probably has more to do with the change of rates as opposed to their current level. Keeping rates low will not have the same effect going forward as lowering them. Interest rates do not increase the cost of construction and they only impact the payments during the initial period of the loan. So over the last year we had a reduction in interest rates which helped stoke demand. Another factor contributing to nationwide price appreciation was the change in consumer confidence. Last year when the world was ending it was reflected in falling home values. Now real estate is hot again. This positive change in sentiment will at some point be priced in to the market. Actually, I think the current outlook is too optimistic and going forward it will become more negative.

The current strength of the Canada wide market will not continue much longer (wild guess mid 2010). This is because the contributing factors of increasing consumer confidence and decreasing rates are set to be removed, if not reversed.

Canada wide market
October 2008 $282,583
October 2009 $341,079 +20.7% (weighted average shows 14% increase)

Quote of the day

“If we have 10-per cent-unemployment, that means 90 per cent of people are employed,” he said. “People are re-entering the market – they have the confidence to take advantage of bargain-basement prices. There's been a release of pent-up demand, and that has a long time to play out. Prices have gone as low as they are going to go.”

Gregory Klump
CREA economist
Canada housing rebound sparks fear of a Bubble
Nov 16, 2009

First consider the scenario where headline unemployment is 20% you could make the case that it's not so bad because 80% of people* are employed. Well if you did you would be wrong because that case is called a depression.

*Actually, if using the headline number it would be 80% of people in the labour force and not include discouraged workers. Also employed would include people who are forced to take part-time positions because they are unable to find full-time work. That is why 8.5 or 10% headline unemployment is really bad.

Next, what bargain-basement prices? Nationally, the Canadian housing market has reached new highs so its simply false to imply that buyers are taking advantage of any serious price discount. I would expect a chief economist to know where prices are.

A final point, while I believe some of the increase in sales this year was the result of pent-up demand I disagree it has a long time to play out. The Canadian housing market was experiencing strong sales into 2008, and achieved high home ownership rates. The downturn in sales started the second half of 2008 until spring 2009. So we had at most one year of below demographic sales from which pent up demand could accumulate, I would expect this to be consumed shortly, if it hasn't been already.

Street view

Sheldon and Sara have setup streetview on their Edmonton Real Estate search site. I heard about Google street view awhile and was looking forward to the day I could take a virtual stroll around Edmonton.

Anyway here are some notable places I visited today.

Garner Andrews, a morning DJ of the nearby Sonic radio station always brags to be broadcasting from Edmonton's used hubcap district. Here it is.


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Next is Edmonton's very own giant bat. Some might think I am posting this ironically, but this is not the case. Edmonton is among the greats in the Giants of the Prairies.


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While trying to get a good view of a more conventional landmark I couldn't help but notice this vintage turquoise mystery building.


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Feel free to link to your favorite Edmonton locations in the comments.