What Causes Mortgage Defaults?
Recently, Rob Carrick interviewed Rick Lunny from the Melrose Management Group to discuss mortgage defaults. Lunny explained that the main reason people default on their mortgage is not rising interest rates, but people losing their jobs.
Lunny said that he had “been involved in studies that go back 30 years, and you see that unemployment is the number one reason for mortgage default.”
Let’s take a look at the history of Canadian interest rates for the past 30 years:
The trend of dropping interest rates should smack you in the face. How could Lunny’s study say much about whether rising interest rates lead to mortgage defaults? Apart from 1988 to 1990, Canadians haven’t had to face much in the way of rising interest rates in the past 30 years.
Keep in mind that it’s not high interest rates that cause your payments to rise. After all, the bank takes into account current interest rates when they decide how much to lend to you. What causes your payments to go up is the increase in interest rates. And we just haven’t had enough sustained interest rate increases over the last 30 years to learn much about their effect on mortgage defaults.
Lunny is no doubt correct that losing a job is a big reason behind defaulting on a mortgage. But his studies don’t tell us much about what will happen in the future if interest rates rise significantly. For all we know, rising mortgage payments due to rising interest rates may become an important cause of mortgage defaults as well.
This illustrates the problems you can get into when you use past data as a model for the future. Obviously, interest rates can’t drop another 14% over the next 30 years. So, our interest rate future is guaranteed to look different from the past 30 years.
Lunny said that he had “been involved in studies that go back 30 years, and you see that unemployment is the number one reason for mortgage default.”
Let’s take a look at the history of Canadian interest rates for the past 30 years:
The trend of dropping interest rates should smack you in the face. How could Lunny’s study say much about whether rising interest rates lead to mortgage defaults? Apart from 1988 to 1990, Canadians haven’t had to face much in the way of rising interest rates in the past 30 years.
Keep in mind that it’s not high interest rates that cause your payments to rise. After all, the bank takes into account current interest rates when they decide how much to lend to you. What causes your payments to go up is the increase in interest rates. And we just haven’t had enough sustained interest rate increases over the last 30 years to learn much about their effect on mortgage defaults.
Lunny is no doubt correct that losing a job is a big reason behind defaulting on a mortgage. But his studies don’t tell us much about what will happen in the future if interest rates rise significantly. For all we know, rising mortgage payments due to rising interest rates may become an important cause of mortgage defaults as well.
This illustrates the problems you can get into when you use past data as a model for the future. Obviously, interest rates can’t drop another 14% over the next 30 years. So, our interest rate future is guaranteed to look different from the past 30 years.
Another big factor is downpayments. In the US crash equity was a big predictor of defaults.
ReplyDeleteIn all that history of Canadian corrections, we've had not only dropping interest rates, but also until recently required substantial downpayments. So when the last big housing correction in Toronto saw some 20-30% knocked off house prices, defaults increased, but still stayed quite low in an absolute sense. That experience may not be repeated with many owners going into a correction with little to no skin in the game.
@Potato: I haven't tried to dig up any data on past and present distributions of home equity, but I can certainly see that lower equity increases the chance of default.
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