Low rates allow low repayments. So do longer terms. But neither seem rational. Irrational expectations of long term capital gains keep the structure together

Rates can go either way over the very long term

By David Chaston

High house prices cause mortgage payment stress.

Low interest rates give buyers a better ability to afford those prices.

However low interest rates allow buyers to bid up prices to their loan repayment affordability level.

That is why many analysts point out that it is low interest rates that ’cause’ high prices when there is limited supply. That is, low interest rates expand the pool of buyers who can ‘afford’ higher priced houses.

This is the basis of the claim that there is an ‘asset price bubble’ in the housing markets, especially in Auckland, Canterbury, and the Central Otago Lakes region.

But from an individual buyer’s perspective, keeping weekly or monthly mortgage payment levels within a household’s budget are an essential criteria for deciding whether to try and buy, or not.

Interest rates may currently be low (in fact, there is an outside chance they could even go lower), but they are not the only technique you can use to keep weekly or monthly payments low.

You can also push out the term of the loan.

Twenty five years ago, a standard home loan term was 15 years.

But since then we have seen it creep up to 20 years, then more recently 25 years.

Now many banks will accept 30 year terms for their mortgage documentation.

The longer the term, the lower the regular repayment amount.

But there are two serious catches.

Firstly, if you want to have your home loan fully repaid by the time you retire at say age 65, you would need to start repaying that loan by age 35.

Secondly, ‘going long’ on the repayment will mean you will be paying the bank seriously more in interest.

It is eye-watering.

Before you choose to take out a longer mortgage, take a look at this table.

It only shows the interest component of what you will pay back. You will need to add the loan principal to get the total repayments you will need to make.

Home loan interest costs
based on a $300,000 loan, plus  
An interest rate of … 5.60%* 6.00% 6.50% 7.00%
over … $ $ $ $
15 years will cost … 144,096 155,683 170,398 185,367
20 years will cost … 199,354 215,830 236,813 258,215
25 years will cost … 258,066 279,871 307,686 336,101
30 years will cost … 320,005 347,515 382,633 418,527
* the current average bank two year fixed rate is 5.58%

This table also shows what will happen if interest rates rise. The downside to household budgets will be serious if rates over a 25, 30 or 35 year period rise even one or one and a half percent.

Over a long period you have contractually accepted the obligation to pay back the principal. But you have also opened yourself up to accepting market rates over that period. Who knows what and when rates will do over such a long period.

A thirty year loan at the current two year fixed rate of 5.6% (the bank average) will see you pay more in interest ($320,005) over that period than you borrowed in the first place ($300,000).

A relatively small rise in interest rates to just 6.5% would see a 25 year mortgage require more in interest than the original borrowed amount.

No wonder there is a reliance on capital gains. Such prospects are a mental salve to justify taking on such a large interest-paying obligation. But that is irrational over such a long period.

However, long term rationality does not feature much when housing markets get exuberant.