When people bought their homes 5 years ago everyone was afraid they were buying overpriced properties. Flash forward 5 years later and all these homeowners are millionaires especially those in the GTA and Vancouver areas. That makes many GTA homeowners ecstatic because they’ve seen the values of their homes grow from a mere $600,000 to $1.2M. That’s a $600,000 tax free gain in 5 years with a small 5% down payment of $30,000. Where else can you find that 2,000% gain?
As a homeowner back in the early 2012, it was not uncommon to get a 30 year amortized mortgage to keep monthly costs low. On top of that, the banks were offering 1.99% mortgages with cash back to essentially make down payments $0. This let many people qualify for mortgages because the rules were so lax and interest rates were so low.
No doubt it kick started one of the hottest runs we’ve seen in real estate, as many people purchased homes that were highly leveraged. This paid out handsomely, however, as interest rates stayed low, even dropped and prices continued to skyrocket with double digit percentage gains for over 5 years straight. But now the story is starting to change.
Over the past year the US Federal Reserve and the Bank of Canada have been hiking up interest rates. With the recent increases the current 5 year mortgage at major banks sit around 3.5%. That’s a far cry from the 1.99% interest rates that many homeowners bought into.
The greatest fear of any homeowner is the increasing monthly mortgage payments that come along with high interest rates. Falling prices don’t have as much an affect from a cash flow perspective as rising payments do. Falling prices are just psychological, because homeowners who don’t plan to sell are not affected. But rising interest rates has an immediate impact on the pocket book as mortgage payments start to jump on renewal.
At the beginning, the price of the house was quite affordable on a 30 year amortized mortgage with 5% down payment.:
Even a 1 bed condo in Toronto and Vancouver cost just as much to rent right now. Imagine the deal home owners got when houses were only $600,000 and 1.99% mortgages were given out like candy on Halloween.
Where things get a little hairy is what happens after the 5 years. Houses are now $1.2M, but interest rates are also 3.5%. What does the renewal look like for a home owner that bought for $600,000 5 years ago?
First we figure out how much is left on the mortgage after the first 5 years:
Automatically the home payments have now reached $2480.76. That’s an 18% increase in monthly mortgage payments that the home owner needs to pay. That’s a pretty big impact even if the home was bought 5 years ago at $600,000, but he payments are still quite reasonable for a detached home in a major city.
So what happens 5 years later when the mortgage rates might eventually rise up to 5.5%? Again we figure out how much money is left on the mortgage after 5 years of paying it.
And taking that amount and remortgaging over 20 years now will now obtain:
From the original negotiated mortgage to new rate 10 years later, the monthly payments have now moved even higher to $2,934.01. That’s a staggering 39.6% more in monthly payments, on a house that was originally only bought for $600,000!
No One Knows The Final Price
Perhaps one of the greatest risks that no one ever talks about including real estate agents, mortgage brokers, bankers or even mom and dad is what the final cost of the home is going to be. Since Canadians have the popular practice of signing only 5 year term mortgages, home owners are always on the hook to renegotiate their mortgage when the term is up. This has risks. It’s impossible to predict where mortgage rates will be in 5 years. They could stay the same or they could go up, but back when the Bank of Canada had near 0% rates, it was obvious that rates had nowhere to go but up. And now that’s are happening.
What buyers thought was going to be a $600,000 purchase price for their home turned out to be more than they bargained for. No home owner will ever remember the interest they paid on the mortgage, they only ever remember the original purchase price. But just how much has the owner paid after 15 years in the above scenario?
- During the first 5 years $126,099 was paid. $52,977.54 being interest that the home owner will never get back
- The following 5 years $148,845 was paid. Of which $80,671.66 was interest
- Finally in the last 5 years $176,040.60 was paid. On that $107,865.01 was interest
In total over 15 years of owning the home, the home owner will have paid $450,984. Even after all of that house will still have a $360,528.41 mortgage. If we add those two figures, halfway through owning the home, the home owner will be looking to pay $811,512 on their home. This assumes no more interest will be paid on the mortgage, which won’t be the case. It’s not hard to imagine then that by the end of the mortgage of 30 years with 5% down payment, the home owner will have paid roughly $1M towards the home that was originally bought for $600,000. That’s a full 66% more than the owner thought they might be paying.
30 years later, no home owner will say they paid $1M for their home. They only bought it for $600,000 and when it comes time to sell it might sell for $2M and the owner will assume they made $1.4M in profit, but that might actually not be true. That’s because we never know what we actually ended up paying because of the unknown interest rate. The only thing we do know is that the bank made out rich like bandits.
How Much Will You Pay Now?
Perhaps the scariest thing that home buyers in expensive cities like Toronto and Vancouver face is that average detached home prices are well over $1M dollars. In the case where rising rates made a $600,000 home cost $1M after 30 years, we’re no doubt looking at these $1M plus homes costing near $2M when the entire mortgage is paid off.
Given how expensive monthly mortgages already are, it will be extremely difficult for home buyers to make extra payments without sacrificing a large part of their daily standard of living. That’s why it’s important to decide. Are the costs of home ownership the lifestyle choice that you want to make? Remember, owning a home isn’t for everyone. Everyone has different goals in life. Buying a home is a great choice, but for some, the costs outweigh the benefit of freedom, travel and stress. What’s your choice?