Sunday, December 27, 2009

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.


Carioca Canuck said...

Only problem with these numbers IMHO is that in most, if not all cases, we have people who are fully overextended financially, with little to no skin in the game buying property worth twice as much down here in Calgary.

So the question IMHO many families (or singles) can take an extra $700 net hit ($1,100 pretax) to their bottom line each and every month under scenario #3?

The Lorax said...


Read the posting again, under that scenario it is the rate the "rent and wait" guy will be paying, NOT the guy who bought and probably locked in a rate of 4.1%. How will they take on the extra hit? Well if they locked it in for 5 years hopefully they would have gotten their financial house in check so that they can absorb this supposed higher rate. But that is five (maybe 10 if some signed for that) years out.

The Lorax said...

Not to mention that with the rates rising from 4.1% to 7.1% under the hypothetical scenario... you should do your math. They are NOT taking on an extra $1000 hit pretax each month in payments. They may have to pay about 400 more per month at most.

Carioca Canuck said...

People in Calgary right now are often paying twice as much, or more, than folks in Edmonton in mnay cases.

When rates go up, you can argue the semantics of the $400-$500-$600 net monthly payment increase all you want, unless you have the extra income to make it that is.

And that was my point......