Expert Eye – Minding the interest rate trap

The mortgage supposed to make things easier for you should not become a burden

I read an interesting advertisement some time ago which I couldn’t forget. On offer was a mortgage with an interest rate of 3.99% fixed for two years, no exit fees, no bank arranging fees and, not surprisingly, claiming to be the best deal in the market. From the looks of it, it was a good deal indeed.

However, it begs the question that every prospective mortgagor needs to ask, that is, what type of interest rate will they be paying in the future? There is no doubt
that paying 3.99% interest for two years is an attractive proposition, but given
that most mortgagors will be paying off their home for at least 20 years, careful
thought must be given as to the effects of rising interest rates, inflation, lifestyle changes, and changing personal expenditure patterns.

It is not a question of whether or not interest rates will rise, but when. As the world slowly returns to a semblance of reasonable economic growth, inflation, important for economic growth and sought by every economy, will become a factor. A modicum of inflation is desirable (the US Federal Reserve is targeting 2%); however, as inflationary momentum accelerates,interest rates also increase to keep inflation under control as excessive inflation is highly undesirable for all of us.

This eventuality needs to be understood by mortgagors as the attractive 3.99% interest rate enjoyed today will, in all probability, be replaced with a significantly higher rate in two years’ time, requiring increased mortgage payments to cover the interest rate hike.

Consider the following simple example. A 20-year mortgage for Dh2 million with an interest rate of 3.99% will require a monthly payment of Dh12,109. An increase in interest rates to 5.99% on the same mortgage would require a significant increase of approximately 18% on the monthly payment. For the purpose of reflection, this is what happened to many mortgages in the United States leading up to 2008. The inevitable rapid growth in mortgagor defaults became a major factor in the bursting of their real estate bubble that had developed over the preceding six years, and the eventual onset of the global financial crisis.

So careful analysis is required by the mortgagor who needs to envisage his or her economic circumstances at least two years into the future. The question to be answered is: “Given my projected earning capability and desired lifestyle, what mortgage payment increase will be financially feasible and acceptable to me in two years’ time?”

There are several factors at play here. First of all, estimating a projected earning capability can be a little daunting. We all hope to progress rapidly in our professional (a.k.a. financial) pursuits, but there are generally more people disappointed than delighted with their achievements. And as history has shown, salary increases generally tend to lag behind cost of living increases so conservatism in estimating future cash flow is a must.

Then there is lifestyle. Is there a new baby planned in the near future? A new car perhaps? What effect will significant family or lifestyle events have on disposable income? Are there existing children who will need to start school in that time frame? All these events will have an effect on disposable income and, thereby,will decrease one’s financial flexibility to address interest rate shocks.

And finally, what is financially feasible may not be acceptable. How much sacrifice are you and your partner willing to make to service your mortgage? What are you willing to do without, and what lifestyle changes are you prepared to make? Once again, being honest with oneself is paramount.

So, notwithstanding economic recoveries and resurgent markets, cautious financial planning based upon realism and honest self reflection is key when planning the purchase of your dream home. Your future depends on it.