Yesterday, I opined on how the Canadian housing market might actually make sense. Today, I’m going to talk a bit about why the market doesn’t make sense, and why I think it’s in for a serious correction.  There are a myriad arguments against buying real estate at the moment; here are just a few of them.

A low interest rate environment makes it a dangerous time to buy

A lot of people I talk to seem to have trouble understanding that this low interest rate environment actually makes for a terrible time to buy.  Everyone knows that these low interest rates won’t last forever — but the prevailing sentiment is to lock in before rates go up, which on the surface seems to make sense.  But what these people don’t realize is that, when rates go up, the cost of housing must come down, since we must maintain the same level of affordability.  (I firmly believe that we’ve reached the limits of affordability…. If you still think prices are going up in the near future, because of immigration or higher wages or whatever, I’m all ears, but please back up your assertions with some hard data.)

In other words, if buyers are already stretched to the limit to buy a $600,000 bungalow at today’s historically low interest rates, no one is going to have the means to buy that bungalow for $600,000 when rates go up.  The price of the home has to come down.

Now, would you rather buy a house today for $450,000 at a 7% mortgage rate (pretend for a second that mortgage rates are at 7% today)… or would you rather buy that same house for $600,000 at 4%?  If you picked the former, you win the prize.  It’s much better to owe less at a higher rate; that rate actually has a chance to come down.  On the other hand, if you pay $600,000 today at 4% interest, it’s absolutely certain that rates have nowhere to go but up, so your monthly payments are guaranteed to increase in the future.  25 years is a long time to pay off a loan, and I can guarantee that you won’t be paying a mere 4% on your loan 10, 15, or 20 years from now.

“Even if you lock in a five-year mortgage rate, you have to realize that five years from now, they will be significantly higher….” – CIBC economist Benjamin Tal

Canada’s 5-year terms are effectively teaser rates

25-35 years is a long time to pay off a loan. So why is a 5-year amortization the norm in Canada?  In the U.S., it’s common to lock in to a rate for 30 years, which provides peace of mind — you’ll know what your monthly payments are for the entire term of your loan.

In Canada, the staple mortgage product is the 5-year fixed rate.  And after 5 years, you can be sure that your rate will be significantly higher.  In effect, it’s not much different than an ARM or a teaser rate that got so many Americans in trouble during the U.S. housing collapse.

Loan-to-income ratios are out of whack

At the peak of the U.S. housing bubble, just before it burst, house prices were five times the average American income.  In Canada today, we are at 7.4 times the average income — almost 50% higher.

Debt-to-income ratios are out of whack, too

At the peak of the U.S. housing bubble, the debt-to-income ratio for the average American was 127%. Today, the debt-to-income ratio for the average Canadian is at an astounding 142%.

A housing boom in the midst of a recession

Few stop to think about the absurdity of a housing boom in the middle of a recession.  This has never been the case in recessions past.  For example, in 1989, the market collapsed 28% and didn’t bottom out for five years; it didn’t return to its 1989 peak values for another nine years.

Even bank economists think a bubble is forming

A roundup of bubble comments that the major banks have been making lately.  The prevailing sentiment is that a bubble is forming or has already formed, and come mid-2010 when the Bank of Canada raises rates, we might see the start of a shake-up in the real estate market. Bad news like this is rarely seen in the mainstream media, so when so many noted economists publicly voice this opinion, it’s a good idea to perk up and listen.