Housing Affordability

I overheard a conversation in which one person was lamenting to another that as interest rates rise, housing affordability will worsen and soon only 1% of people will be able to afford to buy a house. I’m sure that was an exaggeration, but I’m still interested to look at the scenario.

How many people pay cash for a house? Not many, I’m sure. Almost all buyers have a mortgage of some size. Recently, the length of a mortgage that CDIC would insure was reduced from 40 years back to 35, but hopefully not too many buyers took advantage of the longer amortization. Let’s use, as an example, an amortization of 25 years. What is likely to happen to house prices as interest rates change?

Let’s assume a $400,000 home (pretty typical in Calgary) and an interest rate of 5%. The 25 year cost, at monthly payments of $2338.36 is $701,508. If interest rates fall to 4%, I would expect the house price to rise to $443,000. In that case, the total cost would remain $701,508, no change for the buyer. On the other hand, if interest rates rose to 6.25%, I would expect the house price to drop to $354,500. Again, no change in the total cost to the buyer. While the house price changes with shifts in mortgage interest rates, there is no real change in affordability on average.

I say “on average” because the total cost depends on the amount of debt, the length of the amortization and the interest rate. Let’s see how the total cost changes for buyers who pay cash, compared with buyers who were “lucky” to get a 40 year amortization. For the buyer paying cash, the total cost is the same as the nominal costs above. A rise in interest rates (from 5% to 6.25%) would result in a price that is $45,500 lower, whereas a lower interest rate (4% instead of 5%) would result in a price that is $43,000 higher. In contrast, the buyer with a longer amortization will benefit in the opposite way. If interest rate were to rise as above, total cost would rise from $925,819 to $966,067, an increase of $40,248. If interest rates were to drop as above, total cost would fall from $925,819 to $888,705, a decrease of $37,114. On average, affordability should remain unchanged while house prices move inversely to interest rates, but the actual change in cost will depend on a buyer’s level of indebtedness.

Real changes in affordability stem  from shifts in supply and demand. As an example, around 2005, Imperial Oil moved their head office to Calgary. At the same time, many Imperial Oil employees moved from Toronto to Calgary. The price of our 1550 sq ft, two storey home jumped from roughly $250,000 to around $400,000. That wasn’t the only source of net immigration to Calgary, but a sudden increase in demand without an offsetting increase in supply caused house prices to jump, driving down affordability for everyone (notably my younger siblings).

What happened during the US housing meltdown? During the period 2000 – 2007, interest rates consistently fell while mortgage terms stretched longer. This pushed house prices up (lower rates), but also brought costs to borrowers down (lower rates). Apparently, many renters became first time owners, increasing the demand. Increasing demand pushed up prices further, but reduced affordability (increasing total cost), causing banks to respond with “creative” mortgages (teaser rates, balloon payments) which further lowered costs to borrowers in the short-term. But once the teaser rates expired, affordability suddenly worsened for owners who were heavily indebted, and when sales (added to new construction) first surpassed purchases, supply began to outstrip demand. That pushed housing prices back down (market mechanism), sparking a panic.

A US-style housing meltdown has so far not affected Canada. The question that continues to surface from time to time is: could it? I can see two scenarios where the danger is a real possibility. First, residents could migrate away from Calgary (and Vancouver, Toronto and other cities that experienced a jump in house prices) back to lower priced markets (such as the Maritimes). This seems less likely as long as the economy recovers and jobs continue to be available in metro areas. Second, as interest rates rise, owners may encounter trouble as they try to renew their mortgages. Higher interest rates mean a higher monthly (and total) cost, but this can be offset by extending the amortization. My guess is that the worst case would be that some people who over-extended their borrowing will continue to own a house with a 35-year mortgage, continually renewing for 35 more years. Short of an economic meltdown (which luckily seems to have mostly bypassed Canada) or a demographic shift (the baby boomers all try to sell at once), house prices seem likely to remain relatively stable.