It has been nearly a decade now since the mortgage lending debacle in the United States caused a meltdown in real estate markets, which led in turn to a general crisis in the financial markets and eventually to the Great Recession of 2008-2009.
While no country was immune from the effects of that economic downturn, Canada did not experience the broad-based mortgage lending and real estate crash which occurred in the U.S. There were a number of reasons for that, but chief among them was likely the different regulatory environment of our banking system and in our mortgage lending practices.
Even though Canada was spared the worst of the mortgage lending/real estate crisis, that crisis did lead Canadian financial and mortgage regulators to take a hard look at the state of mortgage lending in Canada. What they saw led them to make several sets of changes to mortgage lending requirements over the past decade.
Without exception, those changes have tightened mortgage lending practices by mandating larger down payments, reducing allowable maximum amortization periods and requiring borrowers to meet increasingly stringent credit-worthiness requirements.
Part of the reason for increased concern on the part of financial regulators has been the combined effect, over the past decade, of a steady rise in real estate values and historically low interest rates on the amount of debt held by Canadian families.
While residential real estate values have been on a steady upward trajectory, the actual cost of carrying the associated debt (i.e., the mortgage) was, starting around 2009, lower than it had been for decades.
In effect, home purchasers could buy more at a lower debt-servicing cost. As well, there was significant growth in the use of a formerly little-known financing vehicle — the home equity line of credit, or HELOC — which allowed current homeowners to borrow against the accumulated equity in their home. (Between 2000 and 2010, HELOCs grew from just over 10% of non-mortgage consumer debt to nearly 40% of such debt.)
An environment where residential real estate values continued to rise provided most homeowners with ever-increasing amounts of equity against which they could borrow. And, quite often, it was possible to make interest-only payments on such amounts borrowed through a HELOC, with no requirement to repay principal. The combined result of these and other developments was that, by the second quarter of 2017, the debt held by the average Canadian household had reached 168% of annual household disposable income. In 2005, that percentage was 108%.
In the face of all of these developments, and in light of the two interest rate increases which have been announced by the Bank of Canada in 2017, it was determined that further measures were needed to regulate the mortgage financing market.
When assessing the credit-worthiness of a would-be mortgage borrower, a financial institution looks at the percentage of household income that will be required to make the scheduled mortgage payments. There are, in fact, two ratios that are utilized to determine a would-be mortgage borrower’s “fitness” to borrow – the Total Debt Service (TDS) ratio and the Gross Debt Service (GDS) ratio.
While each measures the amount of debt servicing and housing costs slightly differently, both seek to determine whether the prospective borrower can realistically manage the repayment of his or her mortgage debt, based on his or her income, the carrying costs (mortgage payments, including principal and interest, property taxes, and heating costs) for the property to be acquired, and the amount of any other existing debt which must be serviced.
Under the most recent set of changes announced by the Office of the Superintendent of Financial Institutions (OSFI), which will take effect on January 1, 2018, lenders will continue to utilize the TDS and GDS ratios to determine a borrower’s qualifications to borrow. However, would-be borrowers will have to satisfy those ratios, not based just on the mortgage financing interest rate which will apply to the mortgage for which they applied, but on the higher of two “theoretical” rates as well.
In effect, borrowers will have to qualify based both on their contractual mortgage rate and on two “what-if” scenarios, intended to measure the borrower’s ability to absorb a future interest rate increase. Most significantly, the new rules will apply to every person who applies for a mortgage on the acquisition of a property, regardless of the size of their down payment. (Renewals of existing mortgages are not affected by the new rules.)
As of January 1, 2018, anyone seeking mortgage financing on an acquisition of residential real estate will have to qualify for that mortgage at the greater of the contractual mortgage rate plus 2% or the five-year benchmark rate published by the Bank of Canada. That five-year benchmark rate is typically higher than current mortgage financing rates provided by Canadian financial institutions.
At the end of October, the lowest interest rate obtainable for a 5-year fixed rate mortgage from a major Canadian financial institution was 3%. By contrast, the Bank of Canada five-year benchmark rate for the same time period was 4.89%. Consequently, a buyer seeking mortgage financing approval under the new rules would be subject to the following calculation:
Contractual mortgage rate — 3%
Contractual mortgage rate plus 2% — 5%
Bank of Canada 5-year benchmark rate — 4.89%
The highest of these three numbers — 5% — is the rate which must be used, under the new rules, to determine the buyer’s eligibility for financing. In other words, any financial institution which might provide financing must assess creditworthiness (using the TDS and GDS ratios) based on a mortgage financing rate of 5%.
Using a rate which is higher than the contract mortgage rate to determine eligibility will clearly mean that the amount of mortgage financing available to a prospective buyer will, in all situations, be reduced. Buyers subject to the new rules will have, in effect, the choice of “downsizing” their expectations in relation to the purchase price (and therefore the size of the mortgage) of the property they wish to acquire, or of accumulating a larger down payment in order to reduce the amount of mortgage financing for which they need to qualify under these new rules.
There’s been a lot of debate on the merits of the upcoming rule changes, and the possible effect of those changes on the Canadian real estate market. That debate won’t likely be resolved any time soon. What is certain, however is everyone involved in a real estate transaction — agent, buyer, seller, and lender — is going to have to adjust to a new reality come January 1.
