Higher Interest Rates May Wipe Out Your Home Equity

Which comes first, the price of a house or the mortgage payment.  At first thought, it looks like the house price matters most.  On second thought, you find people pay what their down payment and monthly payment will allow. That second thought is a cause for concern if interest rates rise very far.  There is a problem if you move.

If payments go up,  people will pay less for your house. They can only afford so much a month for a payment.

Mortgage lenders consider many factors before granting the loan but the ones that matter most are GDS, Gross Debt Service Ratio and TDS, Total Debt Service Ratio.  These are the ratios of the cost of housing to income and the cost to service all debt to income.  GDS is usually in the 32% to 35% range and TDS must usually be less than 42%

Let’s see what happens if rates change and the only factor involves GDS.

GDS is the mortgage payments plus municipal taxes plus heat divided by total pretax income. The minimum down payment in Canada now, is 10% of the purchase price.

Consider a $400,000 house, mid range.  Taxes will be about $4,000 and heat probably another $1,000.  With $40,000 down the mortgage payment at 3% will be about $1,700 or $20,400 annually.  Total housing cost is then $25,400 and at a 35% maximum ratio income must be $72,500.  Presently in Canada there is a stress test using 4.64% as the rate.  With that requirement, income must be $83,500.

Assuming our buyer can meet both, what would an increase of mortgage rates to 6% do to them?

At 6% their actual payment would be $2,300 per month, (a little less if they paid off some principle) and total cost of housing would be $32,600.  Income required would be $93,000 to maintain the ratio, but that won’t matter if they stay in that house and as long as they make the payments.

The problems will arise if they decide to move.

Some realtors will tell you that it won’t matter if the price of your house falls because the price of the one you want to buy will fall too. A push as the gamblers say. That is not completely useful. The buyer for you home has limits on their ability to purchase.

Suppose like you when you bought, they have $85,000 of income or so.  If we assume that the threshold rate is the same as actual by then, their biggest permitted mortgage payment will be $2,050 which equates to principle of $320,000.  Together with their down payment of $40,000, the most they will pay for the house is $360,000.

For the vendor,  it could argue that the price of their new house fell at least the same $40,000, but that is not the problem.  The entire $40,000 decline from $400,000  comes out of equity. By the time you sell, pay fees and move, you will have no down payment for your next home.  No matter that the new house fell more than $40,000, you will be shut out of buying it.

Moves happen for many reasons.  Job, schools, marital breakdown, or a need for more space.

When you do your stress test, be sure you look at more than the affordability of the payment. There is more risk than your ability to make payments, stress test your equity too.

Don Shaughnessy arranges life insurance for people who understand the value of a life insured estate. He can be reached at The Protectors Group, a large insurance, employee benefits, and investment agency in Peterborough, Ontario.  In previous careers, he has been a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business.

Please be in touch if I can help you.  don@moneyfyi.com  866-285-7772

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