Joe is retired, 77 years old, living off small savings and government pensions. Joe also happens to live in a $1-million house with no debt. He and his wife love the house, they have been there 40 years, and don’t want to move. He still remembers paying $100,000 for his house in 1971.
Joe may not realize it, but the latest moves from the Minister of Finance, Jim Flaherty, have hurt his chances of meeting his retirement goals.
Mary is in the top tax bracket. She is 40 years old and wants to grow her wealth intelligently. She believes that in the next five years, she is extremely likely to generate investment returns that will beat her 2-per-cent after-tax borrowing costs (3.65 per cent mortgage with 46 per cent deductibility).
Her goal is to be able to retire at 55 so she can volunteer full time at a community hospice where she is currently helping out. She wants to lock in five-year rates, borrow $300,000 on her $600,000 of real estate equity to invest in a portfolio with a yield of over 4 per cent. She correctly believes that there is a very strong probability that she will come out ahead using this strategy, and can deal with the financial downside in the event that the strategy doesn’t work.
Unfortunately, Mr. Flaherty has inadvertently made things tougher for Joe and Mary. I don’t think this is right.
Even though the new rules are only aimed at “high-ratio” mortgages where someone is borrowing at least 80 per cent of the value of the property, these changes will likely affect all mortgages in short order.
To review the new rules:
- Maximum amortization has been reduced to 30 years from 35 years. Compare that to the previously available 40-year mortgages and interest-only mortgages, with no forced payment of any principal.
- When you want to refinance your mortgage, you can now borrow up to 85 per cent of your property value, down from the 90 per cent available in 2010. Before 2010, you could have borrowed up to 95 per cent.
- The government will no longer provide insurance backing on home-equity lines of credit.
If we look at Joe’s situation, the second rule will have no effect. What Joe needs is to borrow some funds from his $1-million house in order to cover his expenses for the next decade or so. Joe and his wife are very unlikely to still be in their home 10 years from now, and when the house is sold, any debt will easily be paid off.
If Joe manages to get a line of credit, he is now faced with the prospect that the rate will increase in two ways. The first is that as a variable rate, when (not if) interest rates rise, Joe will have higher rates. The second is that in any case where a bank sees greater risk, they raise rates. Without government insurance, even for a small percentage of a bank's line of credit assets, look for banks to hike line of credit rates across the board. If you read the fine print on your line of credit documentation (and who really does that?), the bank has significant flexibility to adjust rates higher whenever it deems it necessary.
If Joe decides he doesn’t want to go the line of credit route, he can likely get a mortgage. The benefit is that there is a mortgage contract, and if it is a fixed-rate mortgage, this eliminates the interest rate risk for Joe during the life of the mortgage. The downside is that he will want to borrow a larger amount than he needs in the short term. Now there is a new downside. Joe isn’t a 28-year-old who needs big brother government to ensure he pays off his debt faster. Joe simply wants to leverage his real estate equity. But guess what? With a 30-year amortization, Joe needs to meaningfully pay back his principal, when that is the last thing he wants to do.
You might say that this 30-year maximum amortization only applies to high-ratio mortgages, but as we saw with a similar ruling on 40-year amortizations, the banks quickly made the change on all mortgages. It will very likely happen the same way this time, with most if not all 35-year amortizations disappearing from the mortgage market.
In Mary’s case, the issue isn’t going to get a lot of sympathy, but Mary has no reason to want to pay the loan down. It is inefficient for her wealth-building strategy to draw down investment assets to pay down a loan. Her strategy is the exact opposite. She wants to borrow to invest. She can pay the loan off after five years – most likely with some meaningful profits left over. Why should Big Brother looking out for high-debt ratios put limits on Mary’s wealth-building strategy? She is fully aware of the risks and rewards and wants to move forward.
When it comes to the new rules, I begrudgingly believe that the government has a right to intervene. After all, around the world we have seen governments (and taxpayers), left holding the bag on insolvent banks and individuals. Nevertheless, is it really OK for the government to make Joe and Mary’s retirement goals more difficult to achieve?
Follow Ted Rechtshaffen on Twitter: @TriDelta1