I get frustrated when I hear comparisons between our mortgage industry in Canada and that of the United States.
We have made important, crucial changes to mortgage rules and regulations, and I’d like to examine a few ideas that experts have for creating a safer mortgage environment going forward…
“If it could happen in the United States, it could happen here in Canada too!”
I’ve grown so tired of hearing that…
Anybody who claims that the mortgage meltdown of the late 2000’s in the United States is a sign of things to come here in Canada has no idea a) what happened in the mortgage industry in the United States five years ago, b) what steps Canada took to change their industry after seeing what happened in the United States.
Canada and the United States share a border, and they are the largest trade partners in the world, but that doesn’t mean that we are joined at the hip in every single thing that we do.
Canada never had the predatory lending practices that the United States put into place, and our investment banks never had the brilliant idea to package sub-prime loans into securities and sell them to the masses.
This was a problem unique to the U S of A, and history shows that we did not follow suit.
But after the mortgage meltdown, the Canadian Mortgage Housing Corporation did bring about some changes that would help stabilize the mortgage industry in Canada, and remove the “risky borrowers” in the process.
We’ve all heard the stories, we’ve all read the books, and we all know the anecdotes; an immigrant cleaning-lady in New York obtains a loan for her fourth investment property in Queen’s. This never happened in Canada, and yet CMHC brought enacted changes to ensure, unequivocally, that it never does.
Here are the four largest changes brought about in the last few years.
1) Amortization Period: 40 Years to 30 Years
I’ve heard other people comment, “They have 100-year amortization periods in Europe, so what’s the problem?”
Well, I don’t want to jump onto that sinking ship, but, isn’t Europe having debt problems right now?
It seems like just yesterday that California introduced their fifty year mortgage! Oh, wait, that was 2006. And nothing bad happened shortly after that, right? Read the article HERE.
A few years ago, CMHC decided to eliminate the 40-year amortization as an option for Canadian borrowers. They cut the maximum amortization down to 35-years.
A few years later, CMHC eliminated the 35-year amortization, thus making the maximum amortization period 30-years, where it remains today.
If a buyer purchased a $500,000 property with 20% down, he or she would pay $328,474 in interest over 40 years, but only $235,926 in interest over a 30 year period (assuming 3.39% interest). But more importantly, the principal/interest ratio goes from 55%/45% to 63%/37%.
CMHC encouraged buyers to take on less debt, pay less interest, and pay off their mortgages quicker.
2) Minimum Downpayment Requirements
I remember selling a $1,100,000 house in 2005 to a client who put down negative equity.
He was on the receiving end of the “107% mortgage financing” package that was available to qualified borrowers. He put down ZERO on the property, and actually received $77,000 back to help pay his closing costs and to do with whatever else he saw fit (buy furniture, take a trip, etc.)
Those times have changed. Dramatically.
CMHC decided that all buyers must have a minimum 5% down, which is something that most people today will look back upon with hindsight and laugh. Most people will say, “Yeah, great ‘decision’ to force people to actually pay to own real estate,” and I wouldn’t blame them. It seems outrageous today to think that once upon a time, people could put down 1% on a property, so long as they qualified.
3) Qualification At 25-Year Amortization
Whether you have a 30-year amortization today, or whether you took advantage of the 35-year amortization periods available up until a few years ago, CMHC rules dictate that you must qualify for your mortgage assuming a 25-year amortization.
Once again, this helps to ensure that minimum standards are met, regardless of the direction the borrower chooses to go, and the interest that he or she decides to pay over the course of the loan.
4) Minimum 20% Downpayment For Investment Properties
This is the most important rule, in my opinion.
The story above about the immigrant cleaning-lady in New York who owned four townhouses is not just an anecdote; it’s a true story, included in Michael Lewis’ book “The Big Short.” If you haven’t read the book by now, what are you waiting for?
But this could never happen in Canada, under CMHC rules.
For any second property, a buyer must make a minimum 20% downpayment.
This ensures that a cleaning-lady can’t take $50 of every paycheque and pay some administrative fee to a predatory lender who will set her up with a zero-percent-down mortgage to buy yet another townhouse that she can’t afford. Wow, how did nobody see the American mortgage crisis coming?
So if you have a primary residence, regardless of how much money you put down, and regardless of your equity position, you MUST come up with, say, $100,000 to put down on that $500,000 investment property. You can’t just go out and get financing to buy those third, fourth, and fifth properties as you continue on your way toward being a self-described real estate mogul.
This rule helps, more than anything, to ensure that Canadians don’t over-extend themselves and try to leverage a few bucks into a real estate empire that they might not be able to afford one day down the road.
Where Are We headed Now?
As first reported by the Globe And Mail on Friday, Ottawa is being urged by some economists to change mortgage regulations even further.
Craig Alexander, the chief economist at Toronto Dominion Bank, has four recommendations on how to proceed:
1) Cut Amortization Period To 25 Years. This would help return us to a level that was in place in 2006 before the Conservative government allowed for the introduction of a 40-year amortization. It seems like the natural progression from 40, to 35, to 30 will continue down to 25.
2) Approval At 5.5%. Mr. Alexander suggests that anybody looking to obtain a mortgage should show that they could still afford the loan if rates rose to 5.5%, from current rates as low as 2.99%. This is similar to the CMHC rule that all borrowers, whether using a 30-year amortization or not, must show that they could be approved based on 25-years. The approval at 5.5% would help to weed out those that couldn’t afford to pay their mortgages if rates went up, and I think it’s a great idea. Rates were as high as 5.99% in 2007 when many of my clients took on mortgages that are now DOUBLE the rate of what is available on the street.
3) Maximum Home Equity Line of Credit (HELOC). As home prices have increased, so too have home equity lines of credit; both in terms of the number of Canadians who have HELOC’s, as well as the amounts. Mr. Alexander suggests that lenders should ensure that any borrower could pay off his or her HELOC within 20 years. Overall HELOC debt has risen from 11% of all consumer credit in 1995 to 50% in 2011.
4) Minimum 7% Downpayment. The current minimum downpayment is 5%, but Mr. Alexander suggests that increasing the standard to 7% will further help to eliminate those borrowers who can barely afford their mortgages.
The idea is not to bring ALL of these changes into the marketplace at once, as that might trigger a downturn in the economy.
Personally, I have no issue with the 25-year amortization, or the approval based on a higher interest rate. But I don’t know if raising the minimum downpayment from 5% to 7% is necessary. If we’re going in that direction, then go the distance and make it 10%. However, borrowers would eventually find other ways to come up with the money, and lenders would wise-up and invent loan packages that would help provide first-time home-buyers with the funds they need.
But it seems every day, you need only open the newspaper to see that somebody, somewhere, is suggesting that change is needed.
Queen’s University finance professor Louis Gagnon was also quoted in the papers last week as he recommended similar changes.
“Canadians are collectively growing more vulnerable,” he says. Professor Gagnon suggested that the maximum amortization period is reduced from 30-years to 25-years, and suggested that minimum downpayments are increased from 5% to 10%.
“I think the key is equity,” he says. “When interest rates go up, those people who have a low level of equity in their homes will have their equity wiped out.”
It seems that many experts agree that change is needed, and they seem to agree on the same points.
Amortization period and minimum downpayments are what worry experts, although nobody seems to be talking about the qualification process, ie. debt-to-equity ratios, employment history, etc.
In any event, I would welcome almost any change to the mortgage industry, as I too fear that many unqualified borrowers are obtaining mortgages in today’s market. We’re nowhere close to the United States in 2006, but let’s try to be proactive instead of reactive.
The bottom line is: Canadians have far too much debt. I think we can all agree on that.
I think that discretionary spending and credit card debt is the issue, but it’s a lot harder to convince today’s 23-year-old moron not to spend $500 every weekend on nightclubs than it is to enact changes to the mortgage industry and prevent those same people from obtaining mortgages that they can’t pay.
But THAT is a topic for another day. Perhaps a Friday Rant…