interest rates

I recently described my business model to a friend, including my use of mortgages to finance rental property.  He was intrigued but was worried about one thing:

Q: What if interest rates go up like they did in the 1980’s? Won’t you go bankrupt?

 

To quote a mentor of mine(Thomas Beyer):

“Complex questions have simple, easy to understand, WRONG answers!”

Keeping this principle in mind, to correctly answer the above question, we need to have an understanding of how our economy works, and the differences in the world of the 1980’s and now. (The differences are HUGE!)

 

Brief History of Money

As we go about our day to day business, it’s easy to forget that the world is changing now much faster than it ever has in human history.  Many changes are recent and we don’t know the full effects of them yet, but here are some of the reasons we are in our current financial situation:

1. The USA became the sole superpower after the WWII, and one of the many things the USA did was take control of the global economy.  In 1944 at Bretton Woods, New Hampshire USA, world leaders met and established the gold standard money system. 1Oz. of gold was worth 35 US dollars, and all countries’ currencies were tied to actual gold in a vault somewhere.

2.  August 15, 1971, for various reasons detailed here, Richard Nixon abolished the gold standard.  The USA could now influence the money supply at will and the economy became dependant on fiat money which is still the basis of our economy today.

3. The fiat money has freely floating exchange rates between the major currencies.

4. Freely floating exchange rates lead to economic peaks and troughs, and various theories have been implemented to control the effects of these changes. One such theory that ultimately failed was a the USA’s contractionary monetary policy that caused the 1980s recession.

5.  The USA is Canada’s largest trading partner (about 75% of our exports) and has the largest economy in the world($16Trillion GDP), still ahead of China($9 Trillion GDP).

(Because of #5,  The Bank of Canada must act the same as what the USA does. “If the USA sneezes, Canada catches a cold.”  To determine what Canada’s fiscal policy will be, we only need to look south.)

 

Current State of Economy

1. The USA is ~$18 Trillion in debt, and spending about $1 Trillion more than it collects in taxes each year.

 

2. The USA printed $85 Billion each MONTH in 2013.  To help put that into context, here is what One Billion in $100 bills looks like:

One Billion Dollars

 

3. $40 Trillion was printed as part of the Quantitative Easing designed to stimulate a recovery after the 2008 subprime crisis.

Printing money has temporarily stopped(as of 2014), but the latest economic crisis has proven one thing:

“A floating currency results in chronic inflation, punctuated by bubbles.” – David Frum

 

4. Our financial system depends on perpetual growth of debt and the money supply. There will always be inflation. The more money is created, the less money is worth.  That is why gold used to be $35/oz and now it is over $1000/oz.  Anything “real” will always “grow” in value as money becomes less valuable.

 

So what does this have to do with the question “what if interest rates increase like they did in the 1980’s?”

First of all, we need to understand what caused interest rates to rise dramatically in the 1980s.  The recession in the 1980s was caused by government reaction to “stagflation” – a nasty combination of high inflation and negative growth – you can read about the 1980’s recession here.

The government response to stagflation in the 1980’s:

stop/slowed printing money, and;

increased overnight lending rates to the ~20% highs that still creates a fear of debt in some people today.

 

This isn’t the 1980’s and here is the proof:

1. USA has printed money, and lots!  $40 Trillion in fact(as above).

2. USA GDP Growth Rate has been positive(in March 2014 was 3.72%), and USA Inflation is currently low at 2.1%.

3. Canadian Inflation is currently at 2%, right on target for the Bank of Canada, and hardly high.

4. Canadian GDP has grown ~12% since 2009.

GDP Growth to March 2014

Source – Stats Can

My friend is very thoughtful and would no doubt have a follow up question to my explanation:

Q: Ok, I get your point, the situation is opposite that of the 1980’s and governments react differently now than they did then… So 20% interest rates aren’t likely… But won’t interest increases hurt your business anyway?

Interest rates on mortgages are a neutral factor to a real estate investor like me, and here is why:

 

1. If interest rates decrease, first time homebuyers can more easily afford my product, causing the demand and price to rise.  Also, if rates decrease, I don’t pay as much on each mortgage payment and my bank account grows faster.

 

2.  If interest rates increase, this will price some homebuyers out of the market for longer, leaving me with a larger tenant pool, because they will still need to live somewhere.

In fact, currently investors have the most favorable scenario! Interest rates are low and this creates incredible cash flow, and a change in Canadian mortgage rules has restricted home ownership to people who can qualify for a 25 year amortization, or who have a 20% down payment.

Due to these Macro market factors, Kamloops has an abundance of quality tenants with stable jobs who in years past would be homeowners, causing the local rental business to become very lucrative and low risk.

 

3. I stress test my portfolio all the time and recommend all investors do so as well. The Bank of Canada announces rate changes 8 times a year, here is an example of some previous announcements:

BoC Overnight Target

There has been no change in the low rates for a while, but when there is it is usually by 25 basis points(0.25%).  For each $100,000 of mortgage debt(with 25yr amortization) that receives an interest rate increase of 25 basis points a ~$13 increase in monthly payments will result.

If the investment property you purchase doesn’t cashflow enough to handle a couple large increases in interest rates, you should have never bought that property in the first place!

And since interest rate announcements are so far apart, investors have plenty of time to sell if the interest rate causes the property to stop being cash flow positive.

 

In Summary

Mortgage interest rates will not rise to the ~20% range we saw in the 1980’s.  Any increases that do occur are more than offset by the cashflow of the properties I select for myself and my partner’s portfolios.

Any comments or questions, please chime in below, or contact me, I’m happy to help 🙂

 

Until next time,

 

Stay S.A.F.E.