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Buyer Beware – Mortgage Rates Set To Rise! December 10, 2009

Posted by DustinRJay in carrying costs, mortgages.
Tags: ,

In my previous post, I had a poll that asked what the biggest perceived supply risk to the real estate industry in Calgary over the next three year horizon.  This was a randomized poll, meaning that the order changed each time.

Well, the results are in and an overwhelming majority selected interest rates rising as the biggest supply risk!

Why is this a risk?  Well interest rates can pull demand forward or push demand backward, but perhaps the biggest impact it will have is on affordability and investor appetite.  What does this mean?  Well if one has a mortgage, and in 5 years the rate is higher and is beyond what you can spend on shelter that means you will be forced into bankrutpcy.  If you are a real estate investor, and your investment depends on leverage, then you may be forced into selling as well if your rent does not cover your increased mortgage costs.  This would cause an increase in new listings, and decrease in sales simultaneously shifting the supply/demand curve for housing.  If this point of equilibrium shifts too much, then it could tip the real estate market back into falling prices.

That being said, it’s not clear that this is a reason for a sharp bust either.  Why?  Well, modest increases in wages of 2% annually over 5 years, and that the loan amount will be reduced due to the principal that is repaid, and that mortgage rates will likely increase only 3%, equals that the majority of home owners who do so today with an understanding of the risks involved and borrow with prudence will likely not end up in arrears.

Buyers who do not understand that mortgage rates are likely to rise risk defaulting when their mortgage is up for renewal.

The following graph shows a forecast for the 5 year conventional mortgage rates over the next 5 years.  The estimated mortgage rate is derived from the historical risk spread relationship over 5 year Government of Canada bond yields.

Note that this forecast is based on BMO’s August 5, 2009 rate forecast.

For more information about the historical relationship between 5 year mortgage rates and 5 year GoC bond yields, one can view this graph, courtesy of Kevin on the Edmonton Housing Bust Blog.