This week (1/17/2011) Finance Minister Jim Flaherty, outlined several changes to mortgage lending rules that are aimed to address the high level of household debt in Canada.
• The maximum amortization period for a mortgage with government-backed mortgage insurance (through Canada Mortgage and Housing Corporation, CMHC) has decreased to 30 years from 35 years.
• The maximum amount that can be borrowed against a home has decreased to 85% from 90% of a home’s equity (market value).
• Home equity lines of credit (HELOC) will not have government-backed mortgage insurance.
The changes will have a direct impact on those who have or are seeking highly leveraged mortgages. In Canada, buyers with a down payment less than 20% (of the value of the home) are required to purchase government-backed mortgage insurance through (CMHC). The new rules will make it extremely difficult to obtain a highly leveraged mortgage that is amortized over a period longer than 30 years, as they would no longer qualify for the government-backed mortgage insurance. The changes will also have a direct impact to those who borrow large sums of money against their home.
Speculative Real Estate Investment
The changes will impact those who dabble in and make speculative investments in the real estate market. Many cannot reasonably afford the investment property and therefore have been seeking highly leveraged mortgages or HELOCs on their principle residence to make the purchase. This has been particularly true in the condominium market, which in recent years has experienced significant price appreciation. However, a maximum of 85% borrowed against a home’s equity, will not curb speculation by much.
First time home buyers
In many cases first time home buyers have less money to put down on a home when compared to older, more established, and wealthier residents. They typically have needed to borrow more, in order to afford a home. In recent decades, first time buyers have been obtaining more highly leveraged mortgages, as well as those with longer amortization periods. The new change will restrict their borrowing options, as well as the amount they can borrow to purchase property. New buyers would qualify for less, which will likely translate into a difference of tens of thousands of dollars. As a result, a home purchase (both condo and low-rise) may be out of their reach.
The rules make aim to limit the number of people purchasing out of their affordability range. In recent years, those who are not as financially astute or conservative have been entering the housing market, or have been purchasing homes that would have been traditionally considered out of their affordability range. Too many people have purchased property without actually being able to afford the costs of home ownership. There is a large financial difference between renting and owning a home. In addition, many people have also been purchasing larger or more luxurious homes without the supporting income.
Over the the last 10 years, the lax rules, easy credit (5% down payments), and longer amortization periods (40 years), encouraged this type of behavior and made people believe that it was acceptable. This has resulted in strained household finances, where many home owners do not have an adequate emergency fund and cannot sustain the mortgage in the event of job loss. By lowering of the amount that can be borrowed against home equity to 85%, the government hopes household will retain more equity in their homes. In recent years, financial institutions and other mortgage lenders have encouraged large consumer purchases be packaged into mortgages, including those that were CMHC insured. By removing government insurance on HELOCs, such loans (and the government) would no longer be exposed to large credit purchases that are unrelated to creating housing.
Indirect Impact To Sellers
If you do not fall into the highly leveraged mortgage category, the rules will likely not affect you directly. Some buyers may become priced out of the market due to difficulties qualifying for highly leveraged mortgages, while others will purchase homes that are more in their price range. The changes are expected to slow buying/selling activity and cool the real estate market. This means that selling a home may take longer than it has over the last 5 years. However, the changes are small, and is not expected to slow the real estate market down much. This may be especially true for areas of low supply such as the Greater Toronto Area and Greater Vancouver Region. As a result housing prices are likely not decrease much or at all, as a result of such rule changes.
Assessment & Recommendations
I think the rule changes do not do enough to curb the extremely high ratio of household debt to disposable income in Canada (144%). Many first time home buyers have been skipping the small home purchase, and jumping right to fully detached singles when their income cannot reasonably afford it. The first home purchased by me and my wife was a small condo, and we moved up from there as our financial situation afforded us to do so. Too many Canadians have bitten off more than they can chew, with mortgages of more than 75% of a home’s equity. I consider loans above that level to be too highly leveraged. Results are amplified by leverage, and in a bad situation high leveraged loans become a recipe for financial disaster. It is expected that and debt levels will remain stubbornly high in Canada for the foreseeable future. It is also likely that credit will continue to tighten which will include more rule changes as well as interest rate increases.
If you are a home purchaser (whether first time or not), I seriously recommend ensuring you can put down at least 25% of your home’s equity, while having a reasonably sized emergency fund, and being comfortably able to support the mortgage if the rates were to increase by another 1 – 2%. When your financial situation allows you to afford a home priced higher, then it would be a suitable time to do so. Aim to avoid any large mistake, that if were to occur, would result in a huge financial setback. This is risk management 101 for the average individual. The principle is the same as it is when making investments. Low risk does not mean low reward.
Thanks and Happy Investing!