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June 20, 2016
Last week the Bank of Canada (BoC) issued its latest Financial System Review, giving us the Bank’s assessment of the “the main vulnerabilities and risks to the stability of the financial system”.
In this latest report, the BoC highlighted “the elevated level of household indebtedness and imbalances in some regional housing markets”, specifically Vancouver and Toronto. The Bank cautioned that “rapidly rising house prices and strong mortgage credit growth are increasing the share of highly indebted households” and warned that “it is unlikely that economic fundamentals will justify continued strong price increases.” The Bank cautioned that prospective buyers in Vancouver and Toronto “should not extrapolate recent real estate performance into the future when contemplating a transaction.”
Not much to argue with there. Purchasers are having to take on more and more mortgage debt as homes in Vancouver in Toronto become more expensive, and the resulting higher debt levels make households more vulnerable to financial shocks. Also, the continued rise in house prices increases the risk that purchasers will base their decision to buy on unrealistic assumptions about the potential for additional gains.
Despite these concerns, the BoC gave no indication that it plans to raise interest rates to try to reign in the rise in household debt levels or to help cool regional housing markets. Instead, the Bank is hoping that the federal government will consider making more changes to its residential mortgage-lending regulations, which can be more specifically targeted at the areas of concern.
Federal Finance Minister Bill Morneau recently confirmed that the government is doing a “deep dive” on the issue, so more regulatory changes can be expected. The key question now is “what changes will our federal government actually make?”
The answer seems pretty clear to me. If fully extended borrowers in the Toronto and Vancouver markets are the main areas of concern, adopting a more rigorous qualifying standard for high-value properties is the most effective way to help mitigate this risk.
Specifically, I think that our federal government should require anyone purchasing a property valued at more than $1 million to qualify using a maximum amortization period of twenty-five years (today these borrowers can qualify using amortizations of up to thirty-five years).
This change would have the most significant impact on the most expensive housing markets, and would only impact high-end buyers. By reducing the maximum amortization period that is used to qualify these specific borrowers, our regulators would be making it harder for the most stretched borrowers to buy in the upper-end of the market, the segment which is most typically vulnerable to house-price corrections.
To be clear, I think that borrowers who can qualify under this tougher standard should still have the option of setting their payments using amortizations of thirty or even thirty-five years. This will allow them to gain more flexibility over the term of their loan by lowering their minimum contractual payments, creating a cash-flow buffer for their mortgage payments. In my experience, borrowers who use extended amortizations for this purpose can, and do, use their discretionary mortgage-prepayment allowances to achieve shorter effective amortizations, so opting for an extended amortization does not necessarily mean that borrowers will end up taking longer to pay off their loan.
Our federal government has made four rounds of changes to the rules used to underwrite our residential mortgages over the past several years, so we have been down this road before, and in hindsight, those changes all proved prescient. But there is added uncertainty this time around because we now have a new federal government that has not yet spoken on this issue. Here’s hoping that they consider the change outlined above if they determine that further mortgage-rule changes are needed.
Five-year Government of Canada bond yields fell another three basis points last week, closing at 0.58% on Friday. Five-year fixed-rate mortgages are available in the 2.39% to 2.59% range, depending on the terms and conditions that are important to you, and five-year fixed-rate pre-approvals are offered at around 2.59%.
Five-year variable-rate mortgages are available in the prime minus 0.40% to prime minus 0.50% range, which translates into rates of 2.20% to 2.30% using today’s prime rate of 2.70%.
The Bottom Line: The BoC has highlighted rising household debt levels and continuing Vancouver and Toronto house-price appreciation as two of the three most significant risks to our financial stability. This makes it increasingly likely that our federal government will make more changes to the rules used for residential mortgage underwriting and, if they do, I think the change proposed above makes the most sense.
4 Comments
Hi Dave,
An interesting take, but something I hope the Govt does not do as it will not solve this particular issue! I think there are a number of things at play that need to be studied before attempting to put forward a solution. My relatively limited exposure to the Toronto market has yielded some interesting trends. Lately, I have been doing a lot of luxury high end condos. Most people who require mortgages on these properties that are priced close to, or over $1M have smaller mtgs and all are 25yr amort or shorter. Besides the escalating prices that are no doubt creating havoc for appraisers, there is another issue. Many high rise condo units in a number of buildings that have been purchased outright are theoretically listed as being owner occupied… but sitting vacant with no mortgages on them (Hidden under the radar). Identifying the extent of this phenomenon is problematic as there is no reporting. As a Lender or an appraiser, how do you wrap your head around the extent of this and the implications of what could happen if the market for Foreign investors tanked (if you could even identify them)?
Hi Bob,
I think we will have to agree to disagree on this one. For my part, I haven’t encountered any of the buyers that your refer to and I help finance lots of Toronto condos. I have heard of absentee ownership being a problem in Vancouver but haven’t come across it here at all (although, in fairness, my experience may not been representative of the broader market).
Our industry always seems reluctant to support lending-rule changes but without the four rounds we have seen thus far, I think a lot of us would already be out of a job. Given the statistical increase in the number of borrowers who are stretching themselves to the upper limits of their affordability in the Toronto and Vancouver markets, I think additional action by our regulators is now appropriate. For my part, qualifying high-value purchases using a maximum amortization of 25-years seems like the best way to address this specific concern.
Thanks for your comment.
Dave
My wife and I do well and are contemplating upgrading to a family home from a condo in the years ahead. We operate CPCCs and have flexibility over the salary we pay ourselves each year with a substantial amount left over. Recently we’ve gone through the exercise of figuring out how much money we need available for a downpayment and how much income we’ll need to demonstrate for the same when we proceed to a move-up purchase in 2-5 years.
The message we’re hearing about downpayments is that we’ll need 20% of the first $1.4M mortgage and 50% thereafter plus standard TDS and GDS ratios used to qualify for other mortgages. For a $3.5M purchase this is $1.3M down as a minimum (nearly 40%). From an debt service perspective – there are a number of fixed costs (groceries, car insurance, and etc) that don’t fluctuate with income leaving more funds remaining than a standard purchaser to devote to a mortgage, if so desired – so I would believe the same debt services ratios need not be so strict.
It is this buyer you’re worried about crashing the Canadian housing market? It would take a pretty substantial drop in the market to put someone starting with 38% equity underwater – compared to say the guy down the hall in the flashy new condo that mustered up 5% and qualified on a 5 year fixed at 2.49%. Either an increase in rates to anything but a historical low or a drop in the market of 6% puts this person underwater and fast.
Hi Oslercodes,
Your email focuses on down payment but my post proposes a change to the maximum amortization period that lenders use when evaluating whether borrowers have enough income to afford their mortgage payment. Specifically, the BoC is worried about the increasing number of borrowers who are stretching to the upper limits of what they can afford to take on large mortgages on high-value properties. In my opinion, reducing the maximum amortization period that is used to qualify these types of loans is a good way to address this specific concern.
To put the income qualifying test I propose in the context of your question above, our policy makers are less worried about a borrower who is putting down 5% of the purchase price and borrowing an amount that is well within their affordable range, than they are about a borrower who is making a larger down payment but whose income leaves them stretched to make their monthly payments. That’s because history has shown that income ratios are the best predictors of whether a borrower is likely to default on their loan.
Thanks for your email.
Dave