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.

Buy vs Rent

The following comparison will illustrate how the low interest rates are reducing payments enough to compete with the rental market. Under more reasonable financing terms mortgage costs are not terribly out of line with the rental market. With more creative financing it is easy to see why sales are currently strong.

First consider this 1716 sqft house in South Edmonton for $374,900

Looking on craigslist for rentals in Edmonton I found the following.

The 1680 sqft house is the closest match. The advertised price is $1500 but after a few months the price increases to $1700.

1680 Square Foot Beautiful house in Edmonton's most popular newly developed community called Ellerslie crossing. The house location is seconds walk from ETS bus stop and kids school buses. Close to all amenities. Its next to South Edmonton Common, Anthony Henday, Calgary Trail and Whitemud. The lake is visible from the bonus room....Starting rent of $1500.00 will increase by $50 on December ($1550), January ($1600), February ($1650) and will get fixed at $1700.00 from March, 2010 onwards.

Comparing full asking price and rent results in a ratio of 220. That is fairly high even though it is from one of the more reasonable priced houses on the MLS (there was only one rental to choose from in the neighboorhood).

Looking at the price vs. rent things are a little closer.

Assuming full asking price, 10% down, 2% CMHC premium, 4% 5-year fixed rate and 25 year am.
$1814/month. $674 of which is principal.

There is a premium here, especially when taxes and maintenance are included. However, after 5 years the balance will be $300,255.

A buyer under these terms will end up paying a moderate premium and pay down some of the principal over 5 years. Meh. Not terribly exciting.

However if a buyer chooses a more risky mortgage a more interesting comparison appears.

Full asking price, 10% down, 2.4% CMHC premium, 2.25% variable and 35-year amortization.
$1192/month. $543 is principal (the first month, at least)

So for $1192/month + taxes + maintenance a buyer can move out of an apartment into a house and become a homeowner. The problem of course is not considering the interest costs for the entire duration of the loan and the effect of this stimulus on the asset price itself. Is this a bubble? Are current buyers the greater fools by recklessly overpaying for houses due to blind faith in future appreciation? Not entirely. Buyers may be incorrectly assessing the risk of future financing costs and not accounting for the asset inflation caused by low rates. This is a more subtle mispricing as opposed to a bubble and due to this I expect a less dramatic unwinding.

The type of financing above is an artificial boost to the housing market. What about the rental market? Low interest rates and creative loans reduce demand for rentals as the monthly payments attract people towards becoming homeowners. While rents have been falling partially due to the weak economy, I think another reason is from these financing terms. If/when these financing terms become less attractive the rental market may gain strength.

But its Halloween so we have to consider we may be in a deflationary depression where everything is toast.