On October 3, 2016 Finance Minister Bill Morneau announced big changes to Canada’s mortgage lending rules, designed to make it more difficult for high ratio borrowers to qualify for mortgages. Why is the government taking this action? As they explain in their press release:
Today’s actions recognize the effect that years of low interest rates and shifting attitudes towards debt and indebtedness have had on the housing market. While the overall Canadian housing market is sound, house prices have risen significantly in some markets, notably Toronto and Vancouver, and some borrowers are taking on high levels of debt.
When even the federal government acknowledges that “some borrowers are taking on high levels of debt” you know the situation is serious.
Real estate agents, mortgage brokers and real estate lawyers are in a panic, worried that these new rules will prevent many real estate deals, already pre-approved, from closing, and that the new rules will kill the real estate market.
It appears that both the government and industry professionals believe that the sky is falling. On today’s show Ted Michalos and Doug Hoyes discuss how the new rules will impact borrowers, lenders and more.
The New Rules: A Stress Test
Under the old rules, lenders were required to “stress test” borrowers applying for an insured mortgage with variable interest rates or fixed interest rates with terms of less than five years to ensure they could make their payments. Under the new rules all insured mortgages must pass the stress test.
Without a stress test you only need to qualify based on the mortgage rate the bank is offering, even if it’s a low introductory or variable rate. With the new rules you must qualify based on the interest rate that is the greater of your actual mortgage rate or the Bank of Canada’s conventional five-year fixed posted rate, which is 4.64% as of October 8, 2016.
These tighter rules will reduce the mortgage amount a homeowner can qualify for at the same level of income. According to RateHub, a household with $100,000 in income and a $40,000 down payment would qualify for a mortgage on a home worth $665,435 (using today’s best mortgage rate of 2.17%), but under the new rules this same purchaser can only qualify for a mortgage on a home worth $505,762.
That’s a significant difference, so after these rules take effect on October 17 there will be a lot of borrowers who won’t qualify for the house they thought they could buy.
Genworth, a big mortgage insurer, says more than one-third of mortgage borrowers would struggle to meet the new rules. That could have a serious impact on house prices, since fewer buyers drives down demand.
The part that scares me the most is Canadians have been increasing their debt based on the equity of their homes because mortgage rates are so cheap. This is effectively going to have a negative impact on housing values in my opinion, which means it's going to have a negative impact on all the levels of debt that people have been carrying and the plans that people have made. So, there's going to be fall out. – Ted Michalos
We know from our Joe Debtor study that one in four (24%) debtors own a home at the time that they file for insolvency with an average mortgage outstanding of $197,137. The average insolvent homeowner had a mortgage ratio of 90%. In other words, 90% of the net realizable value of their home was encumbered by debt.
High debt leads to a high risk of insolvency, and it would appear that this is why the government is implementing these new rules: they want to make it more difficult to get a high ratio mortgage.
But is this government action the best solution to the problem of high debt and high real estate prices?
These new rules only apply to mortgages that require mortgage insurance, which is all mortgages with federally regulated institutions (the big banks) where the down payment is 20% or less. Mortgage insurance is confusing to many people. It’s not like car insurance, where you get paid if you have a car accident. With mortgage insurance, if you can’t pay your mortgage and the bank forecloses and suffers a loss, the mortgage insurance pays the bank, not you.
As I said on the show:
Is it really necessary for the government to protect the big banks who earn huge profits from loan losses? Doesn’t this guarantee simply cause the big banks to lend more money on high ratio mortgages to heavily indebted consumers?
You probably wouldn’t loan a friend $1,000, because you might not get repaid, but if there was a government program that protected you from the loss you would probably be willing to loan your friend $10,000, at a low interest rate, because there is no chance of losing anything.
That’s the state of the mortgage market today: it’s as if the banks can’t lose, so now the government has to put in controls to prevent the banks from lending too much to heavily indebted consumers.
Ted and I are also concerned that if fewer borrowers qualify for mortgages, some of the “monoline” lenders, that only do mortgages, may be unable to compete with the banks that offer many services, and they may go out of business. If that happens, less competition will probably increase mortgage interest rates, and bank profits.
Here’s our advice:
- If you won’t qualify under the new rules, don’t panic. House prices may start to fall, so take the time to build up a larger down payment, and you may be able to use that bigger down payment to buy a house that has dropped in price.
- Where possible, have a down payment of more than 20% to avoid the cost of mortgage insurance.
- Consider all costs before buying a home, since it’s not just the mortgage payment you have to worry about; maintenance and other costs can also be significant.
Learn more by listening to the podcast or read the full transcript below.
Resources Mentioned in the Show:
- Information released by the Finance Minister: Background: Ensuring a Stable Housing Market for All Canadians and Housing Insurance Rules and Income Tax Proposals
- Example of implications of new mortgage rules on RateHub
- Canada Mortgage and Housing Corporation (CMHC)
- RBC financial statements
- Does your mortgage lender matter?
- The impact of high ratio mortgages
FULL TRANSCRIPT show #110 with Ted Michalos
Doug Hoyes: On Monday October 3rd finance minister Bill Morneau announced big changes to Canada's mortgage lending rules. Real estate agents, mortgage brokers, real estate lawyers, they're all in a panic worried that these new rules, scheduled to come into effect on October 17th, will prevent many real estate deals already preapproved from closing and that it will kill the real estate market.
So, is the sky falling? Will the new mortgage rules hurt the real estate market? That's our topic today here on Debt Free in 30. To discuss it today I'm joined by my Hoyes Michalos co-founder and business partner and fellow chartered accountant and licensed insolvency trustee, Ted Michalos.
Ted Michalos: Chartered professional accountant.
Doug Hoyes: Oh, that's right. I'm just bound and determined to continue to use the old name. So, Ted is the sky falling?
Ted Michalos: Alright, well let's start by looking at what the new rules say. All insured mortgages, so anyone that's requiring CMHC or Genworth or any of those other insurance products for mortgages are now going to undergo a stress test. Previously the stress test was only applied to variable rate mortgages and for people borrowing with fixed terms under five years. So, now it basically covers anyone who is putting down less than 20% when they buy a home.
Doug Hoyes: And that could be a significant number. I mean Genworth, which is one of the other insurers like you said, CMHC being the biggest one, but Genworth is pretty big as well, says that more than one third of mortgage borrowers would struggle to meet the new rules.
Ted Michalos: I can believe that.
Doug Hoyes: That's a huge number. So, we know that in late 2015 the Bank of Canada reported that 8% of Canadian households have a debt to income ratio of more than 350% of their gross income. And that's double the rate going into the 2008 recession. So, we're in trouble. I mean that sounds like a big problem to me.
Ted Michalos: Well, and the only way people have been getting away with that is 'cause interest rates are so low. But let's tie this back to some information from our own practice. We know that on in four of our clients own a home at the time that they declared themselves to be solvent with an outstanding mortgage on average of about $200,000. These aren’t average people, average mortgages, but the thing to keep in mind is the average insolvent person has financed their home at a ratio of 90%. In other words 90% of the net value of their house is tied up as a mortgage.
Doug Hoyes: So, these are obviously high ratio mortgages. So, if one third of mortgages and the people who borrow those mortgages would struggle to meet the new rules, that means one third would obviously struggle if interest rates go up. So, that's a big deal. So, okay when do these new rules come into effect?
Ted Michalos: So, effective October the 17th, which is what a week and a half from now?
Doug Hoyes: Yeah, not too far into the future. And the way this stress test works then is you take - it's not based on the actual rate you're paying.
Ted Michalos: No, it's based on the greater of the contract rate for the mortgage or The Bank of Canada's conventional five year fixed posted rate.
Doug Hoyes: Okay, that's a big mouthful.
Ted Michalos: That's a made up number anyways. What The Bank of Canada does is the post the average five year rate, fixed rate from the banks. And they call that the five year fixed posted rate. Right now that's what, somewhere around 5%.
Doug Hoyes: Yeah, 4.64% is when we're recording this but obviously it could be, it could change. So, The Bank of Canada does a survey of the big banks and they're not taking actual real rates.
Ted Michalos: No and they're certainly not taking the best rates. So, if you're a customer that has been with them for years and you're asking for a point off, they'll probably give it to you.
Doug Hoyes: So I go to a bank's website and it says the rate is 5% but I if go in there it might be four and a half of four or something like that.
Ted Michalos: Particularly if you tell them you talked to three of their lenders and they want your business.
Doug Hoyes: So the Bank of Canada is using the high number, which isn’t really a real number so in effect they have inflated how this is going to work.
Ted Michalos: Exactly.
Doug Hoyes: Now I went and actually went online and pulled up one of the banks to see what I would qualify for.
Ted Michalos: And they said no.
Doug Hoyes: They said no, but if I had better credit than a five year variable rate, at this particular bank, was 2.7%. So, I could go in there assuming I've got decent enough credit, qualify based on that 2.7% but under the new rules I would have to qualify at a rate of 4.64%. So, that's going to be making it a lot more difficult to qualify.
Ted Michalos: It's a huge difference to your monthly payments.
Doug Hoyes: Give me some numbers then, what kind of mortgage could I qualify for under the old rules and under the new rules?
Ted Michalos: Well, so I'm not going to do the math myself. We went to RateHub, it's a website on the net obviously. And here's an example for you. A household with $100,000 in income and a $40,000 down payment would qualify for a home worth $665,000 using today's best rates. So, in other words they qualify for a mortgage of $625,000. But under the new rules, subject to that stress test, you know, the 5% interest, they only qualify for a house worth $505,000. So, that means the house is worth $465,000.
Doug Hoyes: Well, and that's a huge difference, you're talking $150,000 difference or whatever that is, more than that.
Ted Michalos: Huge, that's right.
Doug Hoyes: So, huge. So, under the old rules I could get a house for $650,000, $700,000, under the new rules it's, you know, $500,000 or something in that range. So, what do you think that's going to do to house prices?
Ted Michalos: Well, I mean it's got to have an impact on first the starter homes, so the folks that this effects most dramatically are the people getting the homes for the first time 'cause they're almost invariably going to be the ones with insured mortgages. So now instead of looking at that two bedroom detached bungalow or whatever they were looking at, they're going to have to be going down at least one full category. It could be a whole different neighbourhood, I mean it impacts in so many different ways.
Doug Hoyes: Yeah, it could be really significant. Now the other big worry is that there are lots of home buyers who got preapproved for a mortgage. This might have been a month or two ago and they were, you know, they've already purchased the house or the condo or whatever and the deal hasn’t closed yet. And now there are these new rules so, how is this going to muck things up?
Ted Michalos: Yeah, for the next couple of weeks things are going to be crazy. So, what the government said is that the new rules aren’t going to apply to any signed contracts that were dated before I think it's October 3rd. So, anybody who's got a legally binding agreement to purchase a home under the new rules they got preapproval, they're probably okay as long as the closing date is before March 1st of next year. So, that means if you're already in a real estate deal, you've been preapproved, you got the mortgage insurance coming, you're probably okay.
The rule also says that any deals that get penned between now and October 17th will be okay. So, as long as the contract is binding by October the 17th and the closing date is before March the 1st of next year, then the new rules don’t apply. For everybody else or anything else the new rules will apply. So, if you sign an offer this week but you don’t make it legally binding and firm by October 17th, then you've got to qualify at that higher rate. You've got to meet the stress test that they're imposing.
Doug Hoyes: And what we're telling you is what we've read from the finance website.
Ted Michalos: That's right. We took this from the information that the government has published. I mean the specific details will be made available to mortgage brokers and lenders very quickly. But this is what they want people to understand. You've got get the deal done. Well, if the deal's already in place you're okay. If you get the deal firmly signed and committed by October 17th, you're okay. After that the stress test will apply and so you've got to be prepared to get approved for a lower mortgage or significantly higher payments on the mortgage you thought you were going to get.
Doug Hoyes: Yeah and nothing we say on this show should be construed as legal or other advice 'cause these rules are obviously brand new, they're in a state of flux. All we're telling you is this is what is on the press information released by the finance minister. So, if we are interpreting it wrong or if they've put it up there wrong, well things could be different. But the bottom line is you're right, if you don’t have a deal in place then you're going to be under the new rules, it's pretty much as simple as that.
Ted Michalos: Yeah. And the whole purpose of the new rules as far as I can tell is just to cool the market off. What they're trying to do is pre-emptively say mortgage money right now, borrowing money is cheap, 2%, 2 and a half percent for a mortgage is a hell of a deal. They're telling people that well you need to be prepared for mortgage rates to be double that, 5%. I for one don’t see them going to 5% in the next couple of years but -
Doug Hoyes: Well, but in effect they've already done that by saying here's the five year posted rate that you have to match, 4.64% you have to qualify under. So, you don’t have to pay that interest rate but you have to qualify for it. So, it's almost as if interest rates have gone up by a couple of points immediately.
Ted Michalos: And that's got to throw water on the market, it's got to cool things off.
Doug Hoyes: Well and also it means that the preapproval that you got may not been worth that paper it's written on because it's under the old rules. If the deal hasn’t been consummated then you've got a problem. So, if you haven’t locked it in that could be. So, I certainly think there's going to be some deals that don’t close.
Ted Michalos: Yeah, there's going to be fall out, there has to be.
Doug Hoyes: There's simply go to be fall out. Okay, so speaking of fall out, the - we're talking about, is the sky falling? So, what does this all mean? Where do you see this all going?
Ted Michalos: Well, okay so first and foremost it means first time home buyers, young families, new Canadians, people getting into the market for the first time are going to be delayed their entry to the market or they're going to have to revise their housing expectations. They were thinking about moving into neighbourhood A and how they're looking at neighbourhood B or simply a lower value property because they won't be able to afford the payments.
The second thing of course is people who want to sell their homes they're probably looking at lower prices. If there are fewer people that qualify to buy, particularly the lower end of the market, the first time home buyers, then the prices for those properties are going to drop or at least they're certainly not going to climb the way they have been in the last few years. So, it's going to impact people across the range of things.
The part that scares me the most is Canadians have been increasing their debt based on the equity of their homes because mortgage rates are so cheap. This is effectively going to have a negative impact on housing values in my opinion, which means it's going to have a negative impact on all the levels of debt that people have been carrying and the plans that people have made. So, there's going to be fall out.
Doug Hoyes: Yeah and I guess what kind of gets to me is why are we having this discussion? Why is it that the federal government guarantees mortgages? Because the rules is if you have less than a 20% down payment and you are getting a mortgage from a federally regulated lender, so we're talking about the big banks, then you must have mortgage insurance. Canada Mortgage and Housing Corporation, CMHC is the biggest insurer. Obviously we talked about a couple of others. CMHC is a government agency. Ultimately it's back stopped by you and me, the taxpayer.
So, you know, you've got the big banks who, if a mortgage goes bad, can in effect go to the government and say hey, make me whole. The biggest bank is I'm not going to mention their name but their initials are RBC. And when you look at their financial statements for the most recent quarter, their net income was a record, almost three billion dollars, so that's almost one billion dollars a month that the biggest bank makes. Obviously all the other banks also make tons of money.
So, is it really necessary for the government to protect the big banks who earn huge profits from loan losses? I mean doesn’t this guarantee simply cause the big banks to lend more money on high ratio mortgages to heavily indebted consumers? I mean think about it this way. So, Ted, I say to you hey, will you loan me $1,000. And you're going to say no, I know you, you're not -
Ted Michalos: Can we use somebody else?
Doug Hoyes: Yeah, is there anybody else out there I can loan to? But if I said to you wait a minute Ted, there's this government program that will guarantee the loan. It doesn’t matter, even if I don’t pay the government will kick in the money. In that case you'd say okay well, fine I'll lend you ten grand then, what's the big problem?
Ted Michalos: Sure, what's the risk?
Doug Hoyes: And I don’t even have to worry about the interest rate. I don’t even have to make it a high interest rate. Let's make it 2, 3% and that I think in simple terms is the Canadian mortgage market today. You know, the big banks, mortgage lenders and even private lenders can lend as much as they want at very low interest rates to less than perfectly qualified borrowers because if there are any losses, the taxpayer's going to cover them.
I agree that the Toronto market is crazy and it would be nice to tamp it down a little bit to make things a bit more affordable. But I mean is the solution for the government to say to the big banks we're not going to cover for you anymore. If you lose, cover your own losses. Wouldn’t that be a better approach than what we got now?
Ted Michalos: Well, it would certainly tighten up money. I think we need to be very clear about how the mortgage insurance works. You certainly describe it properly but I'm not sure everybody understand this. When you get mortgage insurance, it's not for you, it is for the lender. So, if you default on the mortgage the lender gets their money back. That's exactly what you were just saying but I'm not sure everybody fully appreciates that. They think that when they're getting mortgage insurance, it is covering them, it is not.
So, typically what happens if you unfortunately lose your home, the bank will take your home from you, sell it, make a claim against you and then they'll immediately turn around to the insurer and make a claim against them. They get their money back, that's what you were just saying so they're not at risk. The insurer then has the right to come after you for the money that they had to pay out on the policy. So, eventually, and this is often three, four years down the line, CMHC or Genworth or whomever provided the insurance, is going to come looking to you for that money. Mortgage insurance is not what people think it is.
Doug Hoyes: Yeah. We think of insurance like car insurance. So, if I'm in a car accident and my car gets wrecked, my car insurance company will pay me. Here you go, here's the money, I am insured. But in this case if my house gets sold and the bank loses money, I don’t get the money, the money goes to the bank. It's insurance for the bank.
Ted Michalos: It's a little crazy.
Doug Hoyes: And you and I over the years have done many, many bankruptcies and consumer proposals for people who did lose their house. And you're right, it's always years later that CMHC is coming after them.
Ted Michalos: Yep, it doesn’t make any sense to me, it's just the business model that they follow.
Doug Hoyes: I think the record I've seen is 10 years later. It took them 10 years. They start by taking your tax refunds and everything. But if they don’t recover it fully from you then ultimately it's the taxpayer that's covering it. So, to sum this up let's talk about the future and let's give some practical advice here. So how do you see this affecting borrowers and the real estate market in general? And I know we're not real estate professionals so we're guessing here. How do you see the future?
Ted Michalos: So first and foremost I see this slowing down the bottom end of the market significantly. If the lenders are correct and a third of all people that qualify for mortgages are going to be in trouble based on these new polices then that means it's a third of people that won't be in the marketplace. So, that's going to have downward pressure on prices and it's going to, well it's going to do funny things to the market.
Now what can you do from a practical standpoint to makes sure you're safe? Well, the best way to buy a new home is to not have to buy mortgage insurance at all, so to have 20% down. That's just not realistic for most young Canadians or new Canadians. Many people are still buying properties with 5% down and that's just a risky way to buy a house because you are so leveraged, you're so influenced with what happens with the interest rates. Any kind of upward pressure on interest rates, they go up, you're payments go up and that can affect your ability to make the mortgage payment. That of course is the underlying preemies behind why the government's doing this. They're trying to make sure that if the interest rates do go up, you will still be okay. It's kind of backwards way to do it.
Doug Hoyes: Well, I'm a bit of a conspiracy theorist. I don’t know, is that really why the government's doing it or are there other reasons? I mean you're right, the average detached house in Toronto now costs a million bucks or whatever.
Ted Michalos: Which is crazy.
Doug Hoyes: Who at the age of 25 can come up with $200,000 for a down payment? I mean it is impossible in most cases unless you've got a rich family or whatever. So, I fully understand why people are getting mortgages with 5% down, they don’t have any choice.
Ted Michalos: And that's still $50,000 on a million dollar house so that's still a lot of money.
Doug Hoyes: It's still a huge amount of money. I mean I worry about this. So, you've got this new insurance thing now and the mortgage brokers are freaking out.
Ted Michalos: Yeah.
Doug Hoyes: And there are a lot of companies other than banks that give mortgages. We've got what they call the monoline lenders. So these are companies that just do mortgages, they don’t do line of credits, bank, you know, credit cards, bank loans and anything like that like the banks do. Do you see them being even more squeezed as a result of this?
Ted Michalos: Well, definitely. So, someone who only does mortgage business and there's an impact to a third of the people applying for mortgages is going to take a hit on their top line and their bottom line. It's going to make it much more difficult. I predict that some of these players will probably leave the marketplace, they'll just go. And so, that means there's less choice for consumers, there's less competition for your mortgage dollars, which puts the multifaceted lenders and we're talking about the big Canadian banks here, in a better position. The fewer alternatives you have from borrowing from a bank the better the banks position to be lending you money.
Doug Hoyes: So, if I can quote you here then, what you are saying is these new rules are going to help the big banks.
Ted Michalos: I don’t see how they can't help the big banks because the banks have so many different facets, different income streams. A company that only lends for residential mortgages is now going to take a hit 'cause they'll be a third fewer mortgages written.
Doug Hoyes: And if those - and you already sort of made a prediction here that some of these mono line lenders and probably some mortgage brokers as well end up going out of business as a result of this or leaving the market, well if I'm the guy left in the market I'm in a better position then.
Ted Michalos: Sure. And so, I don’t have to be as sharp with my pencil. We said earlier as kind of a throw away comment. When you see the advertised rate for a mortgage at a bank, you go in and you say I've been a good customer, I want you to take something off, most banks, at least in the past have been in the position to shave off a quarter point or maybe a half a point. Now at current rates a half a point might be difficult but you can get something. You can get a better deal.
Well, the reason they have to do that is because they're competitors in the marketplace, there are other people that are willing to lend you money at that better rate. The fewer people there are competing with the lenders, then the less sharp their pencils have to be, the less inclined to give you a great deal.
Doug Hoyes: Yeah, so if the posted rate right now is 4% and they know you could go to some other competitor and get it for three and a half, well they're likely to match it or lose your business. But if there are no other competitors, if the only competitors are the big banks, then that puts them in a great position.
Ted Michalos: Exactly.
Doug Hoyes: So, there you go, there's the conspiracy theory. Did the big banks go to the government and say we want to - take a run at us, put these stress tests in that makes it look like you're hurting us but really what it's going to do is hurt our competitors even more.
Ted Michalos: Yeah, I'm sure I read that some place in all the analysis that we did for this, that the five big banks actually approved this concept.
Doug Hoyes: Yeah and of course I'm sure they won't admit that but that's probably the case. So back then to wrap this up to the actual person who is listening, you said number one as big a down payment as possible.
Ted Michalos: Always.
Doug Hoyes: What else should you be thinking about before you buy a house?
Ted Michalos: From a practical standpoint it's going to cost you more to own a house than to rent a house. And the rough guideline I always use it's like 125%. So, whatever you rent was for a comparable space, figure that your owning costs will be at least 125% of what your rent used to be. So, if you paid $1,000 it's going to be $1,250. And the reason for that is you now own the property, you're responsible for maintenance, repairs, upkeep. Something is always going wrong when you own a house. For that matter your spouse - you want to paint the rooms this year 'cause they don’t look nice. You need to put new trees and shrubs outside.
Doug Hoyes: New carpet, all sorts of stuff.
Ted Michalos: The neighbour's kid just smashed your window or something. I mean there's always something that happens that's going to cost you more money than when you were renting and you've got to be ready for that.
Doug Hoyes: If the cost of a mortgage ends up going up as a result of this, that's another cost. So, okay so the practical advice is have as big a down payment as possible and who knows if the real estate market does go down as a result of this, for people who have not yet bought a house, this might actually help.
Ted Michalos: That's true. So if you know that you're in the market and you've been looking at something you want to get a deal done, while get it done before October 17th so that you can have the new rules waived. But if you're sitting on the sidelines thinking what could happen, well I predict this will put downward pressure on prices. So you might be better to sit on the sidelines a little longer, increase your deposit, your down payment and you might be in a better position.
Doug Hoyes: Yeah we're moving in to the slower period for real estate anyway, obviously December, January, February are slow months. So, if its slower from that point of view and you've got fewer buyers then it's quite realistic to expect that house prices could be lower in the winter and the spring. Of course we don’t know, they could be higher so you've got to make your decision.
So, okay as big a down payment as you can, obviously saving money before buying, probably don’t be jumping into any deals unless you can do them in the next week or so, otherwise it'll probably be cheaper in the future although -
Ted Michalos: Well, you know what's funny? There will be real estate agents that use this to pressure people to get a deal done in the next two weeks. So, don’t sign anything you're not fully prepared to do. That's a pressure sale's tactic, the rules are changing October 17th, we better get this deal firm but October 16th, be careful.
Doug Hoyes: Limited time loan, limited time only. So, there you go. There's some practical advice, and there's our view on how this is all going to pan out. We don’t know for sure but I'm sure we'll be talking about this over the coming months and as always we'll have lots of information on this on our website at hoyes.com.