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Just How Big a Mortgage Can You Carry?

Posted by Jeff Rubin on December 23rd, 2009 under SmallerWorldTags: , , , ,  • 11 Comments

When money is free, it’s hard not to borrow it, even if the lender keeps warning you to be vigilant against debt. That’s exactly what Bank of Canada Governor Mark Carney has been telling Canadians while at the same time keeping their cost of borrowing as low as it’s ever been.

The obvious question of course is, if caution is warranted in borrowing, why is the cost of money so cheap? Since no one wants to pay more for their loans, particularly mortgage-holders, it’s a question no one bothers to ask Governor Carney.

But ask you should. Because the Bank of Canada’s free-money policy may lead you to places you’d rather not go.

A financial bubble is built on an unsustainable premise. Tomorrow’s bubble in the Canadian housing market is constructed on the premise that today’s record low mortgage rates will remain in place. And that, in turn, is based on the idea that inflation will continue to dissipate in the face of a slack economy.

Neither premise should be in your financial plan.

Today’s inflation rate is no more sustainable than today’s interest rates. Both are rear-view mirrors on where the economy has been, not where it is going.

Energy prices, which were falling a year ago, are now back on the rise. Just as the inflationary impact of those prices triggered the fatal rise in interest rates which, in turn, gave us the deepest postwar global recession ever, energy prices will once again push inflation and interest rates much higher. (See my post Financial Crisis or Energy Shock? for more on this.)

And this time the inflationary fallout won’t just be in the energy component of the Consumer Price Index. The impact will be much broader, as soaring transport prices encourage higher-cost local production to replace sourcing from cheap labor markets halfway around the world.

Stress test your floating-rate mortgage three or four percentage points from today’s level and take a good, long look at the resulting increase in your monthly mortgage payment. For some homeowners, that could be as much as another $1000 per month.

Twenty years ago a similar shock to borrowing rates caused Canadian housing prices to fall by an unprecedented 25 per cent. I know because I called it.

That call was as much about where interest rates were going as it was about where housing prices were heading. Based on current borrowing rates, today’s homeowners will be facing almost as large an increase as they did back then.

So heed Governor Carney’s caution when you decide how big a mortgage you can really afford to carry.

Because once the Bank of Canada starts raising your mortgage rate, it will be a very long time before they stop.

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  • http://oitb.blogspot.com/ Mutasem

    Jeff,
    How do you go short Canadian housing market?

    Thanks

  • http://makeupartistlistings.com/ Constantin

    Hi Jeff,

    I agree with your/Carney caution but the interest rate is low with a reason… to borrow, to fulfill the home dream, etc. I don't think there will be any bubble soon because Canada has a big demand.. I'm thinking at the many immigrants willing to buy.

  • http://oitc.blogspot.com/ Mutasem

    Constantin, you should only borrow when intrest rates are high and falling not when intrest rates are the lowest they have ever been and about to rise. Also when intrest rates are low the housing market is over valued and usually in a bubble as everyone is borrowing to buy because of cheap intrest rates.

  • benisonstar

    Jeff,

    I fear your advice will fall on deaf ears. The fact that it's about 4 years late is also a moot point. Sadly a house is not so much a home anymore as it is a badge of honour, an ATM machine and a right of passage into a classist society. When something is only worth what someone will pay for it, let the bidding wars begin. The bubble will burst, prices will tumble…but only after rates have started their meteoric climb. It will happen. There is sooo much wrong with the real estate business in Canada. For instance, free market capitalism allows for the wealthy to buy as much property they can fill their portfolios with and with the assistance of greedy realtors manipulate prices. Good for the banks, good for the wealthy and good for the realtors. Even in a bidding war a potential buyer is forbidden from knowing the top bid….DIABOLICAL!!

    As a parent, worker and home owner I am disgusted bu the mentality and spin associated with residential real estate specualtion and marketing seen throughout the media today. Simply criminal.

  • zacgraves

    Mr. Rubin,

    First, thank you for this and your other insightful posts. I hope you are able to devote time to this effort long into the future!

    As other commenters have noted, there seems to be a lot of “noise” out there regarding why people should/should not be buying a home now, in the future, etc. Of course, buying a home is a very personal decision and cannot be easily summed up, but the basics economics are hard to grasp for laypersons. For example, it would make sense that we are currently experiencing very low interest rates, but there appears to be inflation looming on the horizon. If that is truly the case, can you explain the basics to your readers? By this, I mean, if inflation kicks in, interest rates should rise, and homes will effectively be worth less because of the decreased purchasing power.

    This is where is starts to get murky for me (and others, I assume). If this does come to pass, does it make more sense to buy now with a low-interest loan (with a more valuable dollar) or wait it out a couple years and buy a cheaper home with more down payment and higher interest rate? I'll give you an example:
    Current: $200,000 house now, $40,000 down pmt., 5% 30-yr fixed
    Future (wild assumptions): same house worth $150,000, $50,000 down, 10% 30-yr fixed

    To boil it down, if you could take emotion out of buying a home, would it be better to buy now or wait until inflation drives the home prices down? Also, to tag onto that, would you please consider commenting on the $8K and $6.5K incentive that America is using to prop up the housing market? It seems that will only bring the tail-end of 2010 to a bitter conclusion in a housing sense.

    Thank you for all your hard work!

    Zac

  • lanel

    Inflation is typically good for real estate as you pay your fixed mortgage cost back with cheaper dollars. Wages usually rise so everyone feels a little better, however everything costs more. Stay away from floating mortgage debt.

  • Duane T

    Hi Jeff,
    I agree with your post and have felt the same concern myself. We've recently purchased in Edmonton with a 3.8% 5 year term mortgage. I plan on paying down the mortgage as quickly as possible, so that when it renews after the 5 years, even though the interest rate may be higher, or loan will be smaller. I have 2 points to make:
    1: people seem to be ignoring the fact that as inflation heats up, all hard assets will increase in price. This includes real estate. As home prices rise 8% per year, a mortage of 6% is costing nothing in real terms and is therefore a 'good deal'.
    2: If people will stop taking out floating mortgages and lock in for 5 years, we should be at another low in interest rates by that time (after the next downturn).

  • duncanhume

    Our governments are intent on stimulating our economies back to life based on theories that were developed Keynes and Freidman in earlier times. Before globalization it was possible to apply a stimulus within a country and see the results within that country. In our globalized age we stimulate North America and watch as China's economy heats up. The model has changed, the old controls no longer work.

  • Todd

    I am about to do this same thing tomorrow. My house is worth about 1 Million, my mortgage is 170k or so now, I am going to lock in at 3.7% for 5 years, and after this 5 year run, I won't have much left to deal with and hopefully Canada doesn't become Visa by then.

  • http://www.everhomemortgage.net everhome mortgage

    The author of this article it totally right when he says “if money is free, it is hard not to borrow it” everybody loves a free item especially if its money. The mortgage companies are tricking us into borrowing large amounts of money then expecting us to pay back what we don’t have

  • http://www.everhomemortgage.net everhome mortgage

    The author of this article it totally right when he says “if money is free, it is hard not to borrow it” everybody loves a free item especially if its money. The mortgage companies are tricking us into borrowing large amounts of money then expecting us to pay back what we don’t have

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