Lately, there’s been increasing interest on where interest rates are going (no pun intended), especially as the housing market in Canada has been running hot, with many projects available and many renters looking to buy.
Until recently, the ongoing consensus was that the recovery was still fragile, inflation was somewhere far in the future, and therefore there would be time before rates would start going up.
Now, the recovery is still fragile, but official inflation is higher than expected, and many banks have already started to raise their 5-year fixed rates.
So, if you’re in the market, looking to buy a home, what do you do? On one hand, you have the bubble crowd which says that housing prices are bound to collapse anytime now; after all, it has happened in many other countries and most notably the US. On the other hand, you have the usual crowd saying that the housing market is strong and high prices are here to stay.
When the outlook isn’t clear, and conflicting opinions abound, it is often good to shut out the noise and take a good look at the fundamentals. BeatingTheIndex.com has a post up about his trading guidelines; they’re well-worth taking a look at, and the same lessons can be applied to the real estate market as well.
First, let’s look at how affordable housing really is. Let’s look at the growth rate of housing over the last 5 years (data from the Canada Mortgage and Housing Corporation Quarterly Housing Market Outlook and Statistics Canada*) against total median income:
*Since income data was only available to 2007, I put the same amount for 2008 and 2009 as incomes cannot have grown much through the recession.
Housing is generally considered affordable when it only costs 3 times the median income; at 4 times it begins to be a little unaffordable, and at 5 times it is starting to get significantly unaffordable.
Interest rates cannot be fully predicted in advance, but they are currently at historic lows and there isn’t really room for them to go anywhere but up.
Although banks will lend you significantly more, do not buy more house than you can truly afford. A good rule of thumb would be to add up all of the expenses from the property taxes, condo fees, utilities, and the mortgage at 5%, and aim for all of this to be no more than 33% of your net income. This way, not only do you have plenty of breathing room in case rates do go higher, but you can also pay yourself first and put away savings and grow your investments. There is simply too much downside risk and not much upside to the market right now, so lowering one’s exposure to the risk is prudent.
Also, consider if you really need to buy that new home. In many markets, real estate prices have gone up so much that renting is once again an attractive alternative. Renting is not necessarily throwing money away if you would be paying your rent or more in taxes, maintenance, insurance, interest costs, and closing fees. In this market we cannot count on capital appreciation for free; eventually, the market runs out of that “greater fool” that continues to drive the price up. Once you add up all the numbers, you might end up spending more on housing than you would have by renting, so it’s important to go over the numbers and see if it is really worth it.
There is a simple calculator which can help give you a rough estimation of the trade-off between renting and buying, if you are entering the market for the first time. Good luck out there, and remember to not be the last one left holding the bag.