Lately, my google newsfeed has been filled with scary headlines like
But on the flip side, there are also articles saying the exact opposite, like:
Some experts say prices could fall as much as 40%, while others think it’s going to go up 15%? That’s a 55% range in predictions! What gives? Who’s correct?
Well, here at Millennial Revolution, we don’t care about feelings (*kicks puppy*), we only care about math.
So, let’s find out by…Mathing Shit Up!
Salary to Interest Rate Comparison
As interest rates rise, mortgage payments also go up. On a variable-rate mortgage on the national average home price of $711,316, if rates rise to above 4% from the current 2.8% by the end of the year, those paying $3,203/month would see their mortgage payments jump to $3,639/month. That’s a scary increase of $436/month!
But interest rate hikes aren’t just going to affect people’s monthly payment. It also has profound impacts on the price of houses themselves.
You see, banks use something called the TDS ratio (Total Debt Service ratio) to determine your loan eligibility.
Typically, this ratio needs to be below 40% to qualify for a mortgage. This is a safety check from the bank to prevent lenders from gorging on too much debt and not being able to pay it back.
With interest rates pushing up mortgage payments and other debts, without your salary going up to compensate, less and less buyers will be able to meet this ratio and qualify for a mortgage. As a result, demand goes down, and housing prices follow.
Let’s go back to that average house in Canada, costing $711,316 in June 2022 (almost double the average of the United States). That mortgage at the current variable rate at 2.8% would be $3,203 per month. Assuming no other debt, in order for a family to stay within that 40% TDS cap, they would have to have to earn…
…$113,872.50 to be able to afford the $711,316 price tag at the current 2.8% variable interest rate.
With a 0.5% increase interest rates (expected in July this year), the monthly payment would increase to $3,381. Therefore, the salary would need to increase to…
Here’s a table showing how much salaries need to increase by as interest rates rise to meet the same 40% TDS cap.
|Interest Rate||Monthly Mortgage Payment||Salary Required to Qualify|
As you can see, there’s a direction link between interest rates and gross salary needed to qualify for a house at a certain price. With interest rates expected to rise to 4.80%, salaries would need to jump 20% from the current rate for buyers to qualify for the same mortgage amount.
But as we know, salaries aren’t keeping up with inflation, let alone the jump needed to offset the interest rate increase.
So what happens if salaries can’t keep up?
House Price Changes in Relation to Interest Rate Hikes
To put it as simply as possible, house prices have to drop.
To understand how this happens, I used this mortgage calculator to reverse engineer the housing price by changing up the interest rate and house price to get back to the target monthly payment of $3,203/month.
Here’s a table showing the results…
|Interest Rate||Monthly Mortgage Payment||House Price||Price Drop|
As you can see, for each 0.5% increase in the mortgage interest rate, the house’s price needs to drop by around 5% to for the same family earning the same amount of money to be able to afford it.
And seeing as how the interest rate on a variable rate mortgage is expected to hit 5% by the end of the year, the housing price would need to drop from $711,316 to $577,500, or 19% if salaries don’t materially change.
I used variable rate mortgages as an example, but the exact same math applies for fixed rate mortgages as well.
Interestingly, after I derived this relationship, I was curious as to whether the rate increases that have already happened follow this rule. I bet you’re curious too, so let’s dive in!
The Bank of Canada raised interest rates by 0.25% in March, 0.5% in April, and 0.5% in June. A 1.25% increase in rates, according to my math, should result the average home declining by about 12.5%. How did the Canadian housing market do so far this year?
Turns out the national average housing price has dropped by 13% (or $100,000) in just the past 3 months. Spot on!
So that means, given that we know the BoC is expected to raise interest rates at least 3 more times this year at least, at 0.5% each time, we should be looking at another 15% drop in housing prices going forward.
That means a total national average housing price drop from peak of 28-32% in less than a year. YIKES!
Those who bought at the peak in Feb 2022 are in for a world of pain. Because not only have their houses decreased in value (and expected drop by at least 27% in total peak-to-trough), their monthly mortgage payment will also increase when they renew. In some cases, they’ve even had to back out of the deal since their appraised value has gone down and banks are no longer willing to lend them the amount they bid. On top of losing their deposit, if the seller sells for lower price to another buyer, they can sue the original buyer for the difference, which means they’d have to cough the money anyways. There’s no escape.
So, who’s winning in this rising interest rate market? Well, the banks, obviously. In fact, the banks are now winning so hard, they’ve posted record profits in the past quarter and as a result have passed those profits on to shareholders (like us) in the form of increased dividends.
And secondly, people who rent and invest. Because even in a bear market, our Yield Shield continues paying us dividends and interest to cover our expenses so we can sleep easy at night. In fact, we’ve had some sweet dividend hikes recently and are now making more money than we expected. We might have to (gasp!) increase our spending as a result!
So for those of you who rent and have been incessantly mocked for “paying your landlord’s mortgage”, and “missing out on all the housing gains”, know this.
Spending all your time arguing with indebted homeowners over the benefits of renting & investing versus home ownership is a waste of time. Here’s what you should be doing instead.
Thank them for paying their mortgage. If you’re properly invested and diversified, their mortgage interest should come back to you as dividends from your bank stocks. You can’t live in a stock, but you can live in a place whose rent is paid for by the dividends from said stocks. So, thank those hard-working home owners for paying your rent. Plus, when they’re saddled with a massive mortgage and can’t afford to travel anywhere like these house-poor Canadians, be grateful that they aren’t crowding your underrated travel spots. Show some gratitude! Thank all those indebted homeowners for working their butts off to support your lifestyle.
And then gently remind them to get back to work.
Regardless of which way the housing market goes, if you structure your investments so that it pays you to own them, fluctuations in the capital value doesn’t matter. You win either way because you’re being paid a passive income to exist. Use that income to live life on your own terms and you won’t have any regrets.
What do you think? Do rising interest rates worry you? How much do you think the housing market will fall?
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