This mortgage loophole puts us at risk

Opt for a five-year fixed rate mortgage and you don’t have to qualify using the posted rate

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If the Canadian housing market were to crash it would be catastrophic. At least, that’s the synopsis of the latest Moody’s Investors Service report.

According to their analysis the six big banks would lose nearly $12 billion while CMHC and other mortgage insurers would be on the hook for as much as $6 billion, but only if Canada were to experience a U.S.-style housing crisis where home values were to fall by as much as 35%.

Apparently, the report was a stress-test: a number-crunching exercise to reveal the worst-case scenario; situations that might occur, like a sharp increase in interest rates or massive job layoffs. But one Toronto mortgage broker is far less concerned about less than probable extreme market corrections.

The five-year fixed loophole

Based out of Toronto, Calum Ross works with high net worth clients as a dually licensed wealth advisor (with his MBA) and as an independent mortgage broker. Over the years, Ross has grown more and more concerned with mortgage qualification rules and how loopholes could contribute to over-leveraged homeowners and a potentially catastrophic future fall-out.

Under current Canadian mortgage qualification rules, home buyers can only get a mortgage if their debt-ratios show that they can make payments based on the Bank of Canada’s qualifying rate. This mortgage qualifying rate (MQR) is based on the posted five-year fixed rate and, as of June 10, hovered around 4.65%.

Even if a home buyer opted for a five-year variable rate mortgage, at 2.4%, they’d have to prove to the lender that they could make monthly mortgage payments based on the 4.65% MQR. On a $650,000 home, with 10% down, that’s a difference of almost $700 per month.

The rationale for using the posted rate to qualify buyers is to “…protect Canadians by ensuring sufficient flexibility to support mortgage payments at higher interest rates in the future, for example, when the mortgage term is up for renewal. This requirement also protects taxpayers who support homeownership through government-backed insured mortgages,” explained the Department of Finance through email.

“But home buyers who opt for a five-year fixed rate are exempt from having to qualify at the posted rate,” explains Ross. “These buyers can qualify at the discounted rate.” In 2015, the average discounted rate for fixed-term mortgages was 2.8%. This mortgage qualification loophole was confirmed in an email from the Department of Finance, which stated: “…borrowers with five-year fixed-rate mortgages may qualify based on their contract rate.” A contract rate is the equivalent of a discount rate—and, at present, about 200 basis points below the stress-test mortgage qualifying rate.

Current loophole, future problems

Discounting the alarming rise in household debt, we don’t see much of a problem with this loophole, right now. But what happens when these five-year fixed mortgages come up for renewal? “Even a 1% increase in mortgage rates will hit homeowners hard, as this translates into an almost 40% increase in their monthly interest costs,” explains Ross.

In essence, this loophole could be creating the Canadian equivalent of a teaser rate—U.S. mortgages that offered low, introductory rates before jumping up to a much higher rate within a prescribed period of time. That’s not to say that Canadian lenders are offering teaser rates or loans with no income verification—two highly problematic practices that led to the U.S. subprime housing crisis in 2007. Thankfully, regulations governing Canada’s banks and mortgage loans are actually quite different than in the United States, and far more stringent, but that doesn’t mean this current mortgage qualification loophole doesn’t pose a threat to the stability of Canada’s housing market.

Market stability is a real issue

According to a December 2015 report by Mortgage Professionals Canada, 67% of all mortgage-holders in Canada held a fixed rate mortgage, while an additional 7% of mortgage holders had a portion in a fixed and a portion in a variable rate. What’s worse is that the number of homeowners opting for fixed rate loans is increasing; in 2015, along, 76% of buyers opted for a fixed term mortgage. Add this to the recent spate of surveys that show Canadians are struggling with debt and the situation takes on a frightening tone. For instance, a recent survey by Manulife Bank, shows that 37% of homeowners were “caught short” at least once in the past year—meaning they didn’t have enough money to cover current expenses. That means in five years, we could end up seeing a large number of homeowners struggling to make payments, even if rates rise slowly and gradually over the next few years.

Of course, this isn’t the first time that household debt has made headlines. For the last couple of years, a number of analysts, including the Bank of Canada, have raised alarm bells regarding the ever-increasing levels of debt-to-disposable income. In the June 17 National Bank Hot Charts report, economist Krishen Rangasamy points out:

Sure, the debt-to-disposable income ratio is high, but it largely reflects record home ownership rates and the sizeable mortgages that were taken to purchase homes in a resilient housing market.

He adds:

A flow to flow comparison such as interest payments to disposable income is arguably more relevant in gauging how manageable the debt actually is. As it turns out, thanks to low interest rates, interest payment as a share of household disposable income is at a record low in Canada. In contrast, capital payments have increased as a share of income, contributing to household wealth accumulation. Overall debt service, i.e. payment of interest and capital, remains manageable as it accounts for 14% of disposable income.

But, Ross asks, what happens when rates start to rise? “Stress test using a 1%, 2% or even a 3% rise in rates and we’re telling a different story.”

So, we ran the numbers. Based on 10% down on a $650,000 home with a 25-year mortgage with a five-year fixed rate of 2.8%, you would have a $585,000 mortgage, which translates into monthly mortgage payments of $2,708.80. Assuming no prepayments over the next five years this is what you’d pay upon renewal: 

 

Mortgage Principal: no rate increase upon renewal 1% increase in rates upon renewal 2% increase in rates upon renewal 3% increase in rates upon renewal

$479,211

$2,606.13 $2,846.24 $3,097.48

$3,359.30

 

“This is a big problem,” says Ross. “By qualifying a buyer at the higher, posted rate we protect the downside risk, the impact higher mortgage rates will have on a homeowner’s budget. In essence, these regulations stress-test whether or not a buyer can withstand a 1% to 2% increase in mortgage rates.” But under the current regulations there is a loophole to this stress-test: Opt for a fixed rate mortgage and you can get a mortgage based on the cheaper, discounted rate. 

“Up until now, changes to mortgage regulations have focused on down payment minimums, but I fundamentally believe that where we really need intervention is in how we qualify borrowers,” says Ross. He believes the regulations need to be further amended so that all borrowers would qualify based on posted rates. “It’s irresponsible to simply ignore this.”

A factor for Morneau’s task force to explore

Just yesterday, in a speech given to a Toronto Economic Club of Canada, Federal Finance Minister Bill Morneau promised to help find solutions to Canada’s heated housing market. His first step towards this was to create a joint working group—an ad hoc collaborative committee made up of municipal, provincial and federal representatives.

During his speech, Morneau explained: “This group will examine the broad range of policy levers and factors that affect supply and demand of housing, the issue of affordability, and the stability of the housing market.”

Part of the group’s mandate is to provide “evidence-based” recommendations on how to tackle Canada’s complex housing market. While measures to slow or impede the rush of money from foreign buyers and the speculative moves made by house-flippers wasn’t ruled out, Morneau also suggested that taxation or additional regulations are also possibilities. “The housing market in Canada is a complex problem; one we are paying very close attention to.”

He added that while getting into the market is a real concern for middle-class Canadians, particularly those living in larger cities like Toronto and Vancouver, the possible devaluation of housing stock was the government’s primary concern. “For people that already own homes, it’s the single largest investment they’ll ever make and we need to make sure it’s safe and secure. Our goal is to protect that investment.”

If that’s the case, then Morneau’s ad-hoc working group on housing affordability and market stability will really need to examine the level of risk lenders pass on to mortgage loan insurers, like the Canada Mortgage and Housing Corporation, and consider closing mortgage qualification loopholes that help stress-test affordability and ensure household budget stability in the future.

 

Read more from Romana King at Home Owner on Facebook »

Correction: This story was amended to reflect that the 40% increase in payments reflects the increase in total interest paid over the amortization of the loan. It should also be noted that the calculations for renewing the mortgage are based on 20 years (a five year reduction off the original 25 year amortized loan). This is due, in part, to a philosophy of buying real estate and paying it off in a prudent manner in order to minimize the overall interest you pay on the loan. 

16 comments on “This mortgage loophole puts us at risk

  1. What a joke. When someone qualifies for this 5 year deal, they need to be rather rich, don’t you think, in order to get through the eye of that needle? And, I wonder how to equate 35% drop in real estate to a measly $12 Billion ? What ever, perhaps ! Yet, a measly $12 Billion is not ever going to harm any banks in Canada, banks that have $Trillion dollar stock market listings and can not be damaged by a small, measly $12 Billion down turn. Now, a $200 Billion dollar down turn, that is a different figure, and possible to do some real damage.

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  2. This is an excellent discussion. The Government of Canada is soley responsible for the escalation beyond reason of the real estate market prices in Toronto and Vancouver. They act like there isn’t a problem. But there is never bad news in Canada, only good news. When the rate increase comes Canadians will not be prepared nor can they be prepared financially. Watch out below.

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  3. By the way, the Morneau task group will do nothing. The uselss tweaking of the minimum downpayment is an example. Adjusting mortgage qualification based on normal not teaser rates woul only affect overheated martkets. It’s a great idea but they will never do it.

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  4. This statement:
    “Even a 1% increase in mortgage rates will hit homeowners hard, as this translates into an almost 40% increase in their monthly mortgage payments,” explains Ross … is totally false.
    The increase would be less than 10% – as shown in the table where the payment rises from either $2.6k or $2.7k to $2.8k – or about $200 extra for each 1% increase in the rate. Not trivial – but not 40% either.
    Was this article fact-checked before it was published?

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    • Hi Peter,
      If rates increase to 3.4% from 2.4%, that translates into a 40% increase, as per the math calculation: 1 is a 41.7% increase of 2.4.

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      • Well Romana, that is a relative increase in mortgage rates, not the increase in “monthly mortgage payments” as stated in the article. Big difference !

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      • Um, Romana…you may want to re-check your statement before doubling down on it. Peter’s assessment is dead-on. Assuming a 1% increase to mortgage rates, there would be an approximately 9.2% increase to payment at maturity as outlined (from $2606 to $2846). If you’re looking for a scare tactic, I highly recommend emphasizing TOTAL INTEREST PAID OVER AMORTIZATION as a illustrative figure.

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  5. This article seems to exaggerate the risks. A $585,000 mortgage at 2.8% does indeed cost $2708 per month but after 5 years the balance is about $498,000. A renewal at 4.8% (a two percentage point increase, not a 2% increase) over 25 years costs $2840 per month. This represents a 4.9% increase on the monthly mortgage payment. Assuming 2% wage growth in each of 5 years, income will rise by 10.4% over 5 years. Hence, the ratio of payments to income will actually fall by about 5.5% (10.4 – 4.9)% The calculations in the article seem to assume that on renewal the amortization is reduced to 20 years whereas it is more likely the amortization will again be over 25 years.

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    • Beddoesarah: The renewal was reduced to 20 years to reflect the priority of paying off the debt–and a prudent strategy for anyone taking on a mortgage. If any homeowner opts to renew their mortgage *and* increase their amortization when they renew then, yes, their monthly payments would go down, but they would increase the interest they pay overall. While there is always a way to increase the amortization to make the debt fit your budget, this is not always prudent financial planning. So the article and the calculations aren’t misleading but based on prudent financial planning.

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      • Your article was not about strategy and nor were my comments. My point stands, the risk due to potential interest increases in the scenario you describe was overstated even if the borrower intends to opt for a 20 year amortization on renewal. A second point is that all assumptions should be made clear so readers can appreciate the context.

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  6. Romana, I do not understand the claim in the article about a 40% increase in monthly mortgage payments. Your example of a monthly payment increase from $2,606.13 to $2,846.24 is an increase of 9%. Can you please explain.

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    • The 40% increase relates to the interest paid on the mortgage payments. A 1% increase on a 2.4% mortgage translates into a 40% increase in how much you pay in interest on the mortgage.

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  7. All mortgage brokers are different. My free Toronto mortgage broker service, for example, shows you hidden costs that you won’t find anywhere else. Not every mortgage broker is the same! Check it out at http://www.GTAMortgagePros.com

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  8. How has no one missed the elephant in this article? 650 000 mortgage less 10% down is nice, but make sure you add back in that CMHC fee of 14 000 that you also have to pay interest on. That fee is typically tacked onto the mortgage for first time home buyers, and so the actual mortgage cost to start is 599 000. Also, the amount owing after five years seem optimistically low. Our mortgage seems to be way more top heavy on the interest to principal ratio in the first five years. Can you please tell me what calculations you used to get the figure of 479 211 after 5 years? Otherwise I think that the idea of increasing qualifications is nice on paper. It would serve us better to educate ourselves and our children about how borrowing works and how to not loose your shirt on a house. We bought based on a realistic budget for our lifestyle, not based on what we would qualify for. It is a pipe dream to assume you will have more money in your pocket in five years to pay for higher rates btw.

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  9. I’ve lived in the States (dual citizen) most of my life as has my wife. We’ve discussed going to Canada but the mortgage system / structure causes serious apprehension. We enjoy a fifteen-year mortgage at a fixed 3.2% in the States. There is no way we could get that in Canada. Despite our retirement incomes being in USD with a 25% advantage over the loonie we still wouldn’t feel secure being exposed to interest rate fluctuations that could be as much as 4% +/-.

    Ottawa really needs to reevaluate law / policy / regulations about fixed rates and longer terms (no less than 15-years). Applicants can be still be vetted for risk factors (i.e., debt to income ratio, employment history, etc.), interest rates can be locked and terms can be extended if we don’t adopt the “anything-goes” US model where the family dog could be qualified for a mortgage. I’m surprised that Canada can have a stable housing market when home owners are exposed to the whims of markets, there is a shortage of homes and home prices are based on current interests rates and their fluctuations as well as demand. Obtaining a new mortgage every five years creates tremendous vulnerability to changing rates that could cause extreme economic hardship. Given the country’s current economic state with the loonie at an all time low an economic implosion with reverberations in the housing market is a real possibility.

    All of this having been said we will either pay cash for a home or rent should we move to Canada. The housing market / mortgage system won’t allow for any other choice.

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