Thursday, April 9, 2009

Be careful what you wish for

Don Quixote
Of late we seem to be hearing increasingly from people predicting runaway inflation... sometimes almost cheerleading for it. For those who bought at the height of the bubble, this may seem on the surface to be an attractive viewpoint as it could quickly erase the downturn in prices.

I'm not really sure anyone that bought at the top should be quick to embrace heavy inflation though... because there is a nasty flip side to it, and that is interest rates. No matter how high inflation goes, interest rates go higher.

Over the last couple decades, it seems all the rage for fiscal policies to be fighting inflation, keeping it in the 1-2% range whenever possible... as a result mortgage rates have dropped from the double digits down to the 5-8% range for much of the last decade or so.

One must only go back to days of more moderate inflation like the mid-80's when inflation was around 4% YOY, and interest rates were regularly 11-12%. Even just a return to moderate inflation could spell disaster for many of those first-time buyers who entered during the boom.

The problem lies in that so many people extended themselves to the max to finance these places, and "get in before they were priced out." To them rates going up a couple points could be too great a cost, much less if they doubled.

Even with the gains in salary that comes with inflation, the interest costs at renewal would be too much. To give you an example, lets say a couple bought a SFH in '07, and financed $400,000 (which depending on the month might only get you the median home in Edmonton FWIW). 5-year fixed mortgage rates at the time were around 6%, and while they didn't have a downpayment, at least they were smart enough to do it with 25 year amortization. Their monthly payments would be $2,577, and like many others, they borrowed to the max of what they qualified for, and could afford.

So they're set through 2012. Lets say that by then inflation has went up to 4% (which historically is quite moderate if not low), but with it interest rates have also shot up to 12%. Now their mortgage is up for renewal, and lets assume the bank is willing to do business with them.

If they want to have their home paid off as planned, their payments will go to $3,960 a month... a 54% increase over what they were paying before. Even with inflation increasing salaries and a raise or two along the way, many wouldn't be able to swing that.

Even doing a complete refinance and taking the maximum term of 35 years, rather then the 20 they had left, they would still have to pay at least $3,600 a month. More than a thousand a month more then before.

Gawd forbid they were amoung the 67% of first time buyers at the time that had a 40 year amortization. Those poor souls would see their payments jump from $2,200, to $3,920 a month, and they wouldn't even be able to stretch out the term any longer. They'd also still owe $386,000 on the house.

Ultimately for all the good inflation would do to incomes to increase buying power, interest rates would more then offset that and would actually cause prices to further decline in the short term. At 12%, for the median house to be affordable at $400,000, the median household income would have to be over $160,000 a year... as of 2006 the median household income in Edmonton was $63,000.

At the end of the day, inflation or no inflation, the average household has to be able to afford the average home... otherwise who will buy it? It's basic supply and demand. Prices may break from affordability from time to time, as we've seen, but eventually they will return. They must.