More money down (on a house), more problems

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Can raising minimum down payments cool overheated markets? In Canada, that’s like performing surgery with a broadsword

My two boys love a cartoon character named Mike the Knight. Every episode, the little lad and his friends break into song and dance as they navigate the tough decisions required to be a good friend and a thoughtful son and to learn to enjoy life in a responsible way. I confess: I like Mike the Knight, too. I’m quite certain if little Mike wanted to buy a castle of his own, he’d weigh the pros and cons, calculate what he could realistically afford and then proceed responsibly.

In fact, little Mike helps me appreciate why there’s an ongoing debate over whether a 5% minimum down payment is still a responsible option in markets where average home prices are galloping over the $1-million mark. Fears of an overheated market, a lack of affordability and the possibility of foreclosures in the future have many questioning if there’s a smarter solution to Canada’s housing market woes.

(Note: Since the initial publication of this column in the January 2016 issue of Moneysense, which came out in mid-December 2015, the Federal government introduce a tiered down payment system.)

One suggestion came early in 2015 from C. D. Howe economist Craig Alexander, who recommended raising the minimum down payment from 5% to 7%. Others have since chimed in, calling for a new minimum of 10%. Turns out government policy-makers may have been listening. According to founder Robert McLister, the feds could make a recommendation as early as January on whether to introduce a graduated minimum down payment system. Based on either the home value or the mortgage amount, a tiered system would let those with homes/mortgages under $500,000 to continue with a 5% down payment, while those purchasing up to $700,000 would need at put at least 7% down. Anything over that would require 10% down.

Certainly there are advantages to a tiered system, but those benefits may do little to address the affordability problems faced by home buyers, nor will it significantly reduce the government’s risk when it comes to insured mortgages. (Defaulted mortgage amounts are theoretically covered by premiums but any shortfall has to be made up by the government.) As such, our elected officials will need to decide: Is this the most responsible action to take? I’m not convinced a blunt, broad-based instrument is the tool to correct a multi-faceted housing market.

Slow the right markets

We know from past regulatory changes that shifts in mortgage lending requirements directly impact real estate sales activity. “Marginal borrowers will be squeezed again and some buyers will have to defer their home purchase into the future, so they can save up that extra 5%,” says McLister. “This potential change will slow the market. We just don’t know by how much.” A price drop might sound great to those struggling to buy in markets like Toronto and Vancouver, but it could seriously hurt sellers in the rest of Canada, says Will Dunning, chief economist for Mortgage Professionals Canada. Outside of these two hot markets, prices have either stabilized or continue to struggle with depressed conditions. (Heck, Fort McMurray saw an almost 45% drop in year-over-year sales by late last year!) Trying to cool key markets by restricting lending laws could end up looking a lot like Hercules fighting the deadly hydra-beast: Cut off one deadly head only to watch two more grow back.

Target the right buyers

Creating a tiered system may not impact enough buyers to even make a real difference in Toronto and Vancouver. According to a September Canadian Mortgage and Home Coporreport, just over a third of Ontario buyers bought a home with less than 20% down in 2014. In B.C. that number drops to 12.7%. That means the vast majority of buyers in these two provinces won’t even bat an eyelash over tougher lending requirements—because they’re already putting down 20% or more.

Nor would these new regulations affect the 41% of buyers who carry mortgage loan insurance despite putting down 20% or more on their home. These buyers have loans amortized over 26 years or longer. Banks eat the cost of buying the insurance in order to minimize potential losses should the borrower default. But the government is still on the hook if there’s a shortfall.

And don’t touch anything else

So the question becomes: Do a minority of buyers who put down 20% or less to buy potentially over-valued homes in two markets warrant more restrictive lending rules across the country? Dunning is worried that by slaying mythical dragons—that is, an overheated housing market—the Feds may damage something more special. “Housing interacts very powerfully with the broader economy,” he says. By mid-2015, housing contributed more than 15% to our nation’s GDP and it’s still holding strong. “It’s our nation’s economic unicorn.”

Instead, the Feds should consider partnering with other levels of government on policies with a more targeted impact on local markets. That could mean adding a tax on luxury homes or streamlining zoning and building bylaws. Either way, I hope they heed little Mike the Knight’s mantra: “Be a knight. Do it right.”

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