Part 4 of 5: The Matter of Interest
There are “two sides to every coin” as they say. Currently, we have seen what happens when we have an over-heated market and prices sky rocket. Sellers cash in their “lottery tickets.” This capital brings more money into the economy. (This was the intention of the Foreign Investor Program discussed in the previous blog.) For instance, Baby Boomers are now set-up for retirement, down-sizing, and cash in the bank; plus, maybe distributing some wealth to their grown-up kids. One of the consequences, however, is the buyers suffer from escalating affordability.
We have also seen, the opposing forces of a Buyers’ market in the United States when people couldn’t sell their homes which was a devastating buyers’ market in some places in 2008. So it is clear that neither a Sellers’ Market nor a Buyers’ Market are healthy for the Vancouver market; although, both markets can make people a lot of money.
The purpose of this blog however, is to talk about the bursting of the bubble of course! So how would this happen? The bubble won’t just burst on its own! What if interest rates jumped?
Well, in an attempt to slow down the market in 2008, 2009, and 2010, the government changed amortization periods. This had the equivalent effect of raising rates. Interestingly, as you can see in our chart below, at the point where amortizations were decreased to a maximum term from 30 years to 25 years, this essentially was the same as raising rates by 1%.
Consider, prior to 2008, with a 35-year or 40-year amortization, you had a longer time to pay off the mortgage and rates were higher. So when you lower the amortization term, and thus the time-line-to-pay, the mortgage payments will have to go up. If you happen to reduce the amortization term but hold the payments constant, in the case below, you will see that magically the effective interest rate declines.
In the example below, using a one million dollar mortgage you can see the effect of changing the interest rate and length of amortization… by “pushing and pulling” the right levers you will find a similar payment amount.
Mortgage Rate Amortization Payment
$1,000,000 4.49 40 $4462
$1,000,000 4.14 35 $4491
$1,000,000 3.49 30 $4471
$1,000,000 2.49 25 $4475
So, what happens when rates go up? Well, the government can choose to roll back amortization again and soften the blow. They now have a counter lever to help the bubble from bursting. Interestingly, what this also illustrates is that people with 25 year amortization terms and buying at 2.49% have the same buying power as someone buying at the 4.49% rate in 2008.
An interesting side note is that in January 2016 mortgages in arrears in BC were only at 0.28%. This would further indicate that people are managing in the current market place and in fact they are doing better than in 2010 when I first wrote about the bubble not bursting. (In January of 2010 the mortgage arrears rate in BC was 0.40 %.)
What else could burst the bubble? Closing the door to foreign buyers? We have seen the government terminate the Foreign Investor Program. Would-be participants have the resources to find another way into the country. The answer is likely yes. Now that foreign investors have experienced our West Coast lifestyle, their interests are likely insatiable.
There are of course always massive global events such as “Nine-eleven Twin Towers event” and the Credit Crisis in the USA that could cause corrections. We can’t necessarily time when an event will happen.
Here’s the thing: safety is boring, banks are boring, and they do not make for sexy headlines… like real estate bubbles. So it’s not heralded by the media. No one really wants to talk about the fact that banks are much more conservative. They now ask for more significant documentation that was not previously required, when qualifying for a loan. Banks have been much more careful with whom they do business and how they do the business. Regulation has played a massive role in Canada protecting the consumer from themselves.
While there could certainly be a shake up, I don’t know if we will see the calamitous depths people are looking for. This is what is known as a black swan event and it could be argued it is really more of a separate issue than the bubble bursting. Of course no one really wishes for this type of event because the consequences will typically reach far beyond simply the affordability of Vancouver Real Estate.
What about affordability? Locals can’t afford to live here! What is the breaking point? Young people can’t afford to live in Vancouver. This is another discussion entirely. As much as some people hope that the bubble would burst so that people may get into the market, the shear will of the masses will not make this happen. I guess the question becomes, can people make it into the market place in Vancouver? Is affordability out of reach, or should we simply put our hands up and give up? Has the paradigm of home ownership shifted? Well these are all a question of perspective (and another issue to cover in another blog).
Look for Part 5 Coming out Saturday Morning!