Canadian real estate owners might be in for a surprise, if they have a variable rate mortgage. Bank of Canada (BoC) numbers show the estimated variable mortgage rate increased by more than a fifth The rise in rates leaves Canadians paying more to their banks, and making less of a dent on that debt pile.
Variable Rate Mortgages
A variable rate mortgage is one where the interest rate is not fixed for the life of the mortgage. Instead of locking in a higher interest rate, a borrower can have their interest calculated monthly, based on the lender’s prime rate. This can either be a win or loss for the borrower, depending on the type they have.
A variable rate borrower pays a fixed sum monthly, but the amount paid towards the principal changes. If rates go down, you pay less interest, and more goes towards principal. This reduces your balance faster, potentially saving you a lot of cash. If your rate goes up, you pay more in interest, and less towards the principal. That potentially can cost you a lot more. Let’s see how that’s changed over the past year.
The Estimated Canadian Variable Rate Mortgage Is Up Over 22%
The cost of a variable rate mortgage has been going up across Canada. The BoC estimates the typical rate reached 2.72% on December 6, up about 2.25% from a month before. The rate is now over 22.52% higher than it was just one year ago. These seem like small numbers, but they have a substantial impact.
Canadian Estimated Variable Mortgage Rate
The estimated variable mortgage rate in Canada.
Source: Bank of Canada, Better Dwelling.
Paying More To Borrow The Same
That’s a little abstract, so let’s talk about the real world impact. A borrower at the estimated rate who borrowed last year, would see their interest payments rise 22.5% higher. If they continue to make the same payments, the amount paid to principal would fall by about 6.6%. At the end of their variable term, the bank finds themselves with more cash. The borrower finds themselves with less of a dent in their mortgage.
After falling for years, interest rates are finally starting to climb higher. Up until recently, variable rate mortgages were working in favor of borrowers. As rates were cut, these borrowers made higher than expected principal contributions. Now the opposite is happening. Variable rates are rising to cool record debt pile growth, but also making it more difficult to pay off the debt.
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Rate cut in 2015 when the economy was actually doing well was a once in a lifetime opportunity to make huge cash on real estate. No one should expect that, considering we’re functioning as an extension of the US and Chinese economies, both of which are expected to enter recession by 2020.
China is about to salt the earth BC’s economy walks on. Most big money investments from China in BC require cooperation from the Chinese government. Canada either holds the CFO of Huawei for months to years while she appeals, or lets her go upsetting the US and demonstrating we don’t follow international law. “Creative incompetence” also made us look sketchy as heck.
Best outline of the situation:
https://economictimes.indiatimes.com/news/international/business/china-warns-canada-of-consequences-if-does-not-release-huawei-cfo/articleshow/67003165.cms
So you want to bow down to a China demands so you can still have the money rolling in??? There is a lot of what Huawei did to get itself in trouble and it been going on for years. Hate to say it, if China could not Borrow the tech that it has now it would never where it is now. I spent 20+years living in Asia and my majors were S.E.Asia and China is well known borrower of Tech and patent rights. I’m also a strong believer in Karma and Karma is starting to rest on China.
Now lets get back to interest rates ……
What happens if rates rise so high that the borrower is paying almost nothing towards principal?
This was actually a part of the issue in the US before the Great Recession.
The borrower pays nothing towards principal, making just payments on interest. Upon renewal, you’ve made no dent in your mortgage, and refinancing changes. If the value of your house falls significantly, you also can have a few issues with the refi. Hasn’t been a problem in places like Toronto or Vancouver in a very long time, but the possibility of an issue does exist.
In the US, no one touches a variable rate mortgage since that’s what “poor people” do. They also have 30 year fixed rates though, since there’s so much more demand for US denominated instruments. In Canada, you’re probably only going to find a 5 year or max, so the perspective is a little different.
What happens when, due to falling real estate values, the equity no longer supports the loan and every payment instalment results in increased debt? At what point does the bank defend itself and take control of those assets?
Big Banks new slogan – ‘we’ll take that house now’.
Only problem is banks don’t want the house, they want those interest payments. A home’s price is only as good as what the bank can collect payments on.
That is a problem. It’s the banks problem that they may solve through liquidation, otherwise they risk going down with the ship like they did in the US.
To pay nothing towards principal, we would have to see interest rates at 100%!
As it stands now, over half of the mortgage payment goes toward paying down principal, which is quite good considering the alternative (renting) would be a cost almost equal to the interest, taxes and maintenance portion for owning the same property.
Using the Canadiam Mortgage App, a 3% variable rate (best rate today is 2.4%, so I’m allowing a 5yr average variable rate of 3%, which seems fairly reasonable), pays $94,800 in interest in the first 5 yrs and $98,500 in principal paydown on a $850K property with 20% downpayment.
For Toronto, the rent would be approximately $2,800 a month (or $3,300+ if located in Downtown Toronto). Even with property taxes and maintenance costs included, the tenant would be on the losing end of the rent vs. buy scenario in today’s market (Toronto, in my case).
Notwithstanding the long term capital appreciation (35yr average annual growth of 6.57% in Toronto as per TREB data), not buying your primary residence, a tax free investment, is a missed opportunity in today’s market and should remain true for the next few years at the very least.
Let’s assume the $850,000 with 20% down and a rent of $3,300 a month (which may be a touch steep, but no worries):
– $95,000 in interest payments at roughly $1,600 a month
– $1,000 a month in other carrying costs (property tax, maintenance/condo fees, utilities which a renter typically would not pay)
– Out of pocket $2,600 a month to own (not including principal payments)
– Profit of $700 a month, ($3,300 – $2,600)
– Yearly return of $8,400 ($700 * 12)
– ROE of 4.9% ($8,400/$170,000 down)
This of course doesn’t include appreciation of the housing market, but I didn’t consider the opportunity cost of owning any other assets either. A 4.9% return is fine, but it’s not risk-free as it requires most to funnel everything into a cyclical asset with high transaction costs. The real value is in the levered capital appreciation.
BUT if interest rates start to rise or rents decrease, not only is the capital appreciation going bye-bye, but that 4.9% cash flow return will start to go bye-bye as well.
To each their own.
JFC, you can’t do math. Not a huge surprise, but it’s probably bad business for you to tell everyone you’re a real estate agent.
For a variable rate mortgage to consume the fixed payments, they would have to double over the term. That’s what people that bought two years ago with a variable rate mortgage are likely to see by the end of their terms, if you believe the Bank of Canada’s plan.
Nothing to see here, just another article for the sake of an article.
This site is getting really lame and predictable.
Tick, tock… Lol! What a waste of time.
You know Jeff’s getting reamed pretty hard when the cost basis for 1/4 of mortgage holders isn’t news to him. Either a schmuck that owns a condo and has his life savings in it, or a schmuck that holds institutional debt.
There’s no problem, everyone keep buying our bonds that are likely to pop.
Tick tock!
Jeff, instead of reading this site, maybe you should go sling some subprime MICs to seniors. I’m sure it would be a better use of your time, than having to read this painful garbage that hurts your eyes.
After all, if you’re so bullish on the debt pile, tell the world. Convert. You’ll be like Jesus, but for shitty assets.
Bullish on a debt pile… Sounds like a losing position in these times.
I agree, very lame. Like when I put a cat in a box and left it for a couple of weeks…people kept on saying “The cats dead” and I’m like “llaaaaammee, that’s what you said like 5 days ago” and they be all like ‘whaaaat! it stinks, that thing is pooched” and then I’m like “nah man, that’s fake news but do you want to buy my assignment below what I paid for it so I don’t have to attempt to get a private loan at 15%+ after getting turned down by convention lenders?” and they just rolled their eyes “well, theres juice coming out of the box, that is gross and that thing is dead”. Waste. of.time. See you tomorrow Jeffy. Tick tock. BD4L.
“Jeff” shows up here under various names to scoff at whatever is printed that day. Have some compassion for him. He thought he’d be sitting on a beach sipping fancy drinks with little umbrellas while the the wealth from his GTA real estate portfolio just kept rolling in. Alas, the market has other ideas, and poor “Jeff” is reduced to trolling bearish RE sites while he waits nervously for things to turn around. Let us all join hands (figuratively) and pray that “Jeff’s” net worth does not turn negative like his cash flow.
Is it true Scotia is one bank that changes the monthly payment accordingly as prime rate moves?
I like reading peoples comments on here. So I’m hoping I can get an understanding into the following: if housing busts in Canada, and the CAD falls significantly to 50/60 cents USD (follws suit with drop in house prices/economic growth/less economic activity), then does the cost of goods and services increase?
Example, if a car costs $20k CAD right now, would the expectation be for the same car to cost $28k/$30k during downtime? Am I missing some sort of economic principle or does my example make sense?
The reason I ask is if I end up getting a car loan right now, calculated with simple interest, to me, it seems more beneficial than getting a loan to buy a car when the economy’s tanked. If I got a loan then, then the car would cost 8k/10k more while still paying simple interest.
I don’t have an ecomonics degree on my end and I couldn’t find an answer to this through my online research.
Thanks.
I also do not have an economics degree but here is my take (hopefully someone will correct me if I’m off base):
I would generally expect to price of goods and services to decrease as the credit cycle rolls over as there will be less money available in the marketplace. As people have less to spend and financing becomes more expensive, prices should decrease accordingly (I would guess the same applies to a car).
I do not think a housing bust and CAD depreciation are necessarily both going to occur simultaneously. I believe the reason CAD would depreciate relative to USD is if the BOC tries to prolong the housing bubble by failing to raise interest rates in step with the FED. If the interest rate differential becomes too high then CAD will tank. I do not know what would happen to USD/CAD if BOC raises rates in step with the FED and housing prices correct.
Again, other commentary is welcome.
Very good article.
What I would like to add here which people often forget/don’t know is that with variable mortgages like this where payment is fixed there could be amortization adjustment.
That means if you got 5y variable with 25y amortization at 2% and now it’s 2.7% then your amortization may exceed 25yrs because your principal payments became lower.
It is prohibited by CMHC and means that at renewal you will be slapped with immediate mortgage payment increase to get amortization back under 25 years.
I didn’t know this but it makes sense. Sweet lord. Tick tock.BD4L.
We have an integrated supply chain for NA autos and despite what many think we have some significant players. The big dog is MAGNA of course. Our loonie will come down but that means, in theory, a lot of the components and materials come down in price as well which balances it out in some areas. Also, you have to think about sales/marketing; increasing a car price in native currency 30% could wipe out demand. think of other markets; people in vietnam don’t pay 100x as much for a car because their currency is a fraction of the USD. Business will find cost effective ways to provide the product. It could mean Canada imports cars made in india or china for example. Who knows, the drop your suggesting would be massive and I’d argue the BoC would need to respond in kind. Tick tock. BD4L.
Nice Article! Thanks for providing excellent information on the property.
Thanks Again!