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

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.

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