- How Owning Individual Stocks Can Destroy Your Portfolio - July 27, 2020
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- How The Hell Are We Going To Pay For All This Stimulus? - July 13, 2020
Yikes, what a week it’s been in the news. It’s never a dull moment these days, is it? And this week is a real kicker. Just as the COVID pandemic made, and broke, the grim milestone of 100,000 deaths in the US, riots are breaking out around the world because of the long-simmering tensions between overly militarized police and Black Americans and people of colour.
So I thought I’d give everyone a break from all the divisiveness and nastiness that we’re being bombarded with in the news and allow us all to focus on something that unites us all: Laughing at dumbass real estate agents.
When the pandemic hit Ontario, Kristina Barybina’s income as a real estate agent dried up and she knew the writing was on the wall — she’d have to sell her own house.
She also knew there’d be a penalty for getting out of her five-year mortgage with TD Bank early — she just wasn’t expecting it to be almost $30,000.
“I thought my eyes were going to pop out,” said Barybina. “It’s insane.”
Today’s real estate road-kill is from Canada. She bought a detached house worth about $675,000. Well, she didn’t exactly “buy” it. That would require her to have money, and none of these real estate people ever have money. The bank bought it for her, and then she proudly took possession as the “owner” because her name’s technically on the deed, but let’s get real here. The bank owns it. It’s the bank’s house.
Could she afford the monthly payments? HELL no! That’s why soon after she took possession she rented out two of her rooms to long term tenants, and then ran an AirBnb out of her guest suite to boot. Her renters and her AirBnb business paid the mortgage, and everything was swell. Easy money, right? The perfect house hack, all built on real estate.
And then COVID hit.
Her day job income dried up immediately as the economy shut down. On top of this, her tenants decided to move back home and shelter with their family. And her AirBnb income, of course, went poof as the tourist industry got slaughtered.
Overnight, she went from free house to a negative cash flow nightmare. Deferrals didn’t help, they just kicked the can down the road. So she sold in mid-March. But when the time came to close out the mortgage with the bank, her eyes popped when the bank decided to charge her penalties and fees over $30,000! She was floored, and then went to the media excoriating the bank for trying to profit from her during a pandemic.
Oh and by the way, before we continue, it’s important to note that this isn’t some poor shmuck who didn’t understand the mortgage documents she was signing. She’s a real estate agent! She’s not some innocent victim here that got tricked into signing a predatory document, she’s the person whose job it is to trick OTHER people into signing predatory documents. In short, she’s part of the problem.
So why is this significant?
It’s Going to Get Worse
Everyone’s hurting right now, but it’s pretty clear that the more debt you have, the more you’re in trouble. And don’t listen to the home boners who like to split off “good” debt (i.e. the debt they themselves have) and “bad” debt (i.e. the debt other people have). Debt is debt is debt.
If you have debt that you can no longer pay, you’re going to be forced to make painful choices that are going to haunt you financially for decades to come.
The only reason why we aren’t seeing mass panic selling in the housing market yet is because banks on both sides of the border have allowed homeowners who can’t pay to defer their mortgages. In the U.S., 7% of homeowners have taken them up on this offer, or about 3.5 million homeowners. In Canada, that percentage is even higher, at 10%, or a million homeowners.
These payments are not forgiven, they will simply get tacked onto the balance of the mortgage later. And more importantly, these deferrals won’t last forever. 6 months from the start of the pandemic, the banks are going to start asking for their money again.
That means that somewhere around September, there will be a flood of people who initially applied for deferral all of a sudden having to deal with their mortgage again, and in many cases that monthly amount will be even higher than before. If they still can’t pay, they will find themselves in the same situation as our real estate agent, which will cause a mass of distressed housing to flood the market. Housing analysts call this the coming “Deferral Cliff”.
Beware the Interest Rate Differential (IRD)
During the Great Financial Crisis of 2008/2009, a national pastime in Canada was to scoff at the Americans and feel smug about ourselves. Sub-prime lending? NINJA loans? No-recourse defaults? What a bunch of yahoos, we thought. We, as Canadians, would never be as stupid as those Americans. It’s different up here.
And to a certain extent, we were right. While our economy got dragged through the gutter along with everyone else, the wave of foreclosures that swept over the US never happened up here.
Well, guess what? It’s our turn to be on the hot seat.
In America, the most popular type of mortgage has a 30-year term, meaning the interest rate and payment stay the same throughout the entire 30 years. In Canada, while our amortization periods (meaning the amount of time it takes to pay off our mortgage) is 25 to 30 years, our terms are only 5 years. That means that every 5 years, we have to refinance or renew the loan at whatever interest rates are current at the time.
American mortgages are also, generally, portable. That means that if they buy a house, then a few years later decide to sell and move, they can just bring their existing mortgage with them to the new house. In Canada if you want this flexibility, you have to specifically ask for an “open” mortgage. Most people opt for a closed mortgage because the interest rate is a bit cheaper.
Closed mortgages are more restrictive. If you sell your house before the term is up, the bank actually gets upset and charges you penalties and fees in order to make up for the interest income they would have gotten.
This is where our real estate agent got caught with her pants down. The penalty she’s specifically referring to is called the Interest Rate Differential, or IRD. Here’s how it works.
The bank takes the Bank of Canada posted 5-year mortgage rate at the time you got the mortgage. Then they subtract the current mortgage rate. Then they take that number and multiply it by your outstanding balance, and then again by the number of years left on your term, like so:
IRD = (OldInterestRate – NewInterestRate) x Balance x YearsLeft
If the interest rate rises or stays the same, then the IRD doesn’t really amount to much. But in a falling interest rate environment, look out because the difference between OldRate and NewRate is going to be quite big.
And of course, the first thing that the US and Canadian central banks did at the beginning of this pandemic is drop interest rates to basically zero. So right now, everyone in Canada with a closed mortgage who’s forced to sell is going to be in the same boat as our real estate agent. The IRD penalty will be the highest it possibly can be.
Real Estate Math is Built on Hope
FIRECracker and I have a disdain for what we call “real estate math,” which is the wildly optimistic math many amateur real estate investors use to justify their increasingly expensive purchases. Here’s how their decision making process typically goes:
- Can I afford the mortgage? If yes, buy. If no, buy anyway and house hack or use AirBnb or something.
- Ignore all other home ownership costs
- Pray really hard that nothing goes wrong over the next 25 years
- Brag about how smart you are
The “it’s always a good time to buy” messaging of the real estate industry flies directly in the face of the cautious and measured way FIRE people spend their money. And during this pandemic, we’ve been keeping in touch with many of our blogger friends and colleagues in the FIRE space. For the most part, their lives haven’t really been that affected. Arguably, we’re the ones who’ve had our lives affected the most because the travel restrictions have locked us to one city, but financially, we’re doing just fine.
But for home boners like our real estate agent, this pandemic is the perfect storm of the worst possible things that could happen to their finances. Whether it happens now or in September’s “Deferral Cliff”, a flood of people will be rushing for the exits. And when that happens, banks will step in to make that transition as expensive as possible.
Before we end the article, I just wanted to leave you with one more thought.
On Friday, the US Bureau of Labour surprised everyone (including myself) with a report that unemployment actually went down in May. Everyone was expecting it to keep soaring higher, but instead, jobs got created rather than lost. And here in Canada, we noticed the same thing, so we know it’s not just Trump fudging the numbers.
In response, the stock market soared. The S&P 500 is within 2% of it’s value at the beginning of the year. Our portfolio is now within 1% of our January 1st value.
For the FIRE people, our downturn is effectively over.
But for the home boners? Their downturn is just beginning.
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