Friday, February 22, 2008

Personal Finance Scenarios

Here are some scenarios for us to consider if one was to purchase a home today with no money down and a 40 year mortgage (a fairly common occurence by all accounts).

Scenario 1: Home Price Appreciates 5% per year for the next five years.

Homebuyer couple buys $350,000 Townhouse in Surrey with 0% down and a 40 year mortgage at a 6% interest rate. They pay the closing costs ($2,500) and CMHC insurance of $12,950. Fortunately for them the home is worth $450,000 in five years when their mortgage comes up for renewal even though they still owe $337,000. edit

Scenario 2: Home Price is flat for 5 years

Homebuyer couple buys $350,000 Townhouse in Surrey with 0% down and a 40 year mortgage at a 6% interest rate. They pay the closing costs ($2500) and CMHC insurance of $12,950 out of pocket. After five years they have only paid down $13,000 of principal and they still owe $337,000. - edit - Not a good situation.

Scenario 3: Home prices decline 30% over 5 years

Same homebuyer couple but after five years their lovely townhouse is only worth $245,000 and they still owe $337,000. What are their options?

They don’t have too many options that make sense as far as I can see besides declaring bankruptcy. I am sure the bank would continue to accept their payments and renew the mortgage but the couple may not be so willing to continue paying for a property that they are so far in the red on. They could walk away and accept 7 years of not having access to credit cards, loans, mortgages but they could pay less money per month and stop the bleeding.

What would be best?

The best thing for them to do in scenarios 2 or 3 is to just rent. In scenario 2 or 3 they could have been paying rent and saving the difference between the rent and the mortgage payment and they would have been much further ahead. In scenario 3 they have essentially ruined themselves financially for a long period of time. Unfortunately I think many of our neighbours in the future will consist of scenario 3 people.

21 comments:

mohican said...

Hat tip to M- and Patriotz for bringing this up in an earlier post's comment section.

Dave said...

mohican....are you sure about the CMHC insurance as when I bought in 1995 it was a one time deal?
on another note, I follow the Walnut grove area of Langley as that is where we want to move to.
Feb 22/07 71 detached houses
Feb 22/08 98 detached houses
the highest I have seen is 103 on May 24/07. 98 in feb seems to be a large increase.
Dave

NumbersGuy said...

I saw Cam Muir give a presentation Wednesday where e forecasts RE in GVRD to go up 7-9% in 2008.

Tsur Sommerville was there as well. Tsur noted that he had concerns over 40% of the condo's downtown being investor owned and that this was unprecedented in terms of what this could mean for the market (he did not sound positive for this specific segment), and generally, he had the Vancouver market as overvalued.

Cam dodged the question, when asked, that given his positive forecast whether he would personally buy a Condo in the GVRD. From that I assume his answer would be no.

Fencesitter said...

Dave, how many of those are in the Yorkston or Bedford Landing developments?

Yorkston would make an interesting case study with the number of completed units sitting vacant, while even more houses continue to be built in the same development.

mohican said...

fencesitter: Yorkson is in the Willoughby area and Bedford Landing is in the Fort Langley area so Dave's numbers exclude these two extremely large developments.

The overbuilding in Langley/Surrey is insane - only to be appreciated with a drive through the area. To see what I'm talking about drive from Fort Langley through Bedford Landing, turn left on 216 to 88 Ave, turn left on 208 to 66th, turn right at 203 to 72nd, turn left to 188, turn left at 68th to 194, turn right on 64 to 168, turn left from 168 to 24 ave, turn right onto king george hwy through Whalley. Leave town, disgusted as you have just seen well over 10,000 housing units under construction.

fun and mental said...

mohican,

are you serious?

are you trying to tell us that you work for a bank and yet don't understand how the cmhc and it's premiums work?

insurance premiums are not payable again on renewal.

they are one time premiums unless you make a material change to the mortgage. ie you increase it down the road. even then the chances are you will only pay a new premium on the amount you increase.

mohican said...

fun and mental - I don't work for a bank per se (I work for a bank brokerage) and I don't work with mortgages at all. I am only going by what I read on CMHC's website. Apologies if I have misunderstood what happens at mortgage renewal. Perhaps someone more in the know than me can comment here.

I'm still not sure about this because many times a mortgage will be renewed at another institution. If what your saying is true then in scenario 2 the mortgage company is willing to lend 95%+ of the mortgage value without any insurance at all. That seems like a boneheaded business move. If the CMHC premium is only payable at first purchase then there must be some provision for further premiums if the lender changes or in a refinance situation.

mohican said...

dave, fun and mental - I checked and you are correct that the "Insurance coverage is for the entire amortization period of the loan and is transferable between Approved Lenders. Provided the payment history is satisfactory, mortgage renewal is easily facilitated since the borrower does not have to requalify."

That is directly from the CMHC website. Refinancing can cause further insurance premiums to be due. Sorry for the error.

Drachen said...

"Home prices decline 30% over 5 years"

What about the most realistic scenario?

"Home prices fall 65% over 5 years"

30% would be completely unprecedented. Never before has a bubble with such a run-up as we've had fallen so little. NEVER. I absolutely dare you to find any historical bubble with the kind of build up we've had (300% more or less) that has fallen only 30%.

M- said...

Mohican and others: I apologize about the factual error on mortgage insurance; my memory wasn't right.

patriotz said...

I absolutely dare you to find any historical bubble with the kind of build up we've had (300% more or less) that has fallen only 30%.

The only runup of that size without a subsequent crash was from the end of the Depression to the post-WWII years but that was no bubble, rather a response to improving fundamentals.

Now think about it. The world became a completely different place from 1938 to 1946. Now just what has changed from 2000 to 2008 in fundamental economic terms, other than most people being a lot more in debt?

JMK said...

300% more or less

300%? Wow, when are you counting from? 1985?

Vancouver has gone up slightly more than 100% since 1997.

I absolutely dare you to find any historical bubble with the kind of build up we've had (300% more or less) that has fallen only 30%.

There is a chart from this very blog that will provide you with an example: Vancouver from 1985 to 1998. Went up 300% (more or less), only dropped about 15% (more or less).

BearClaw said...

I thought CMHC insurance was rolled into the mortgage and added to the balance not paid out of pocket. So if you put 0 down you owe ~103.5% on day one?

Drachen said...

JMK:

Yes, 300%, I am counting from approximately 1987, that is the point where our RE left the historic curve. the "bubble" of the '90s was, IMO actually a feature of the current bubble (most big bubbles have this feature).

The graph you link to is terrible for these purposes because it's not adjusted for inflation.

Patriotz:

Actually it wasn't a "runup" really or a "response to improving fundimentals". I'd say it was more of a return to normal fundamentals which had been thrown out of whack by the Depression and WW2, if you draw a line from pre-depression to post depression prices it's flat with a big chasm between.

Drachen said...

If anyone's wondering what patriotz and I are talking about Here is the graph. Note this is a graph of the United States and only applies to Vancouver in a general way, our runup has been much larger and we never returned to the green "market trend" line after the 1980s.

Drachen said...

I just felt like doing some math. Inflation adjusted prices have risen 375% since the '70s in Vancouver. So it is in theory possible that even my dire predictions are not extreme enough. There is precedent.

Think about it, where else have prices risen that much in RE and retained most of the gains? It is possible that with the myth of the ever appreciating house well and truly busted that prices will return to THAT historic norm.

JMK said...

I think your math is a little off, or this chart is wrong. It shows a 180% inflation-adjusted increase from 1975 to the end of 2007.

We've been over why this is rational and likely to be sustained for the long term in this blog before. The problem with Shiller's analysis is that it excludes most of the effects of densification. As soon as a home is subdivided, torn down for condos, or even substantially improved, it is removed from his database. A far more telling measure, in my opinion, would be the total value of all land over a fixed metropolitan area over time. For all the growing metros in the US or Canada I guarantee that they have outperformed inflation for a long time.

I think you have to be very careful with long-term trends, real or nominal. One of the reason things remained relatively flat from the 40s to the 70s was the growth of the suburbs in most metro areas, facilitated by US interstates and, to a lesser extent, Canadian highway building. The physical expansion of cities has slowed down since then because people can only drive so many hours each day.

Whether you think these long-scale trends will continue or not will inform your decision on whether housing in Vancouver will continue to outpace inflation (on a 10-y time scale). In my opinion, your faith in a return to the zero real-growth trend is misplaced.

Drachen said...

I did my own inflation adjusting.

Median detached home price in 1977, 80k, plug it into the BOC inflation calculator, and it's 277k in current dollars.

I worded it incorrectly though I should have said "risen to" rather than "risen by" 375% ie. prices are 3.75x the inflation adjusted 1977 price.

I don't know where the people who made your graph got their inflation data but mine comes from the Bank of Canada.

Drachen said...

"One of the reason things remained relatively flat from the 40s to the 70s was the growth of the suburbs in most metro areas"

Then how do you explain the flat curve from the 1700s to the 2000s? Not highway building I hope.

"As soon as a home is subdivided, torn down for condos, or even substantially improved, it is removed from his database."

As it should be. If the LAND had increased in value then a house built 100 years ago would be worth more BECAUSE it can be torn down and turned into a duplex or whatever, developers would bid it up if it was undervalued.

"For all the growing metros in the US or Canada I guarantee that they have outperformed inflation for a long time."

Considering we're in the middle of an enormous bubble right now your statement is meaningless because nobody could ever agree when to measure from or to. If you bought in 1982 for instance you did NOT outperform inflation until a couple of years ago.

My opinions are based on hundreds of years of observation of real estate and other bubbles. What are your opinions based on?

JMK said...

I worded it incorrectly though I should have said "risen to" rather than "risen by" 375% ie. prices are 3.75x the inflation adjusted 1977 price.

3.75*277,000 = 1,040,000. I agree that there will definitely be a 30% drop!

jesse said...

"Provided the payment history is satisfactory, mortgage renewal is easily facilitated since the borrower does not have to requalify."

Maybe I'm missing the point of MI. Who does it protect? The way I understand it, if my property is foreclosed on the MI pays the lender off but the MI hounds still come after me for the difference.