The federal government can make longer-term mortgages more attractive to banks and their customers by loosening a stress test for borrowers if they choose terms of 10 years or longer, according to the C.D. Howe Institute.
Mortgages with terms of more than five years are a rarity in Canada, making up just 2 per cent of the total market in 2018. Bank of Canada Governor Stephen Poloz cast a spotlight on the dearth of longer-term loans in a speech last May that urged lenders to make longer-term loans more accessible, raising the prospect that governments or regulators could step in with measures to make them more appealing.
By taking mortgages that renew after 10 years or more, borrowers could be less vulnerable to the threat of rising interest rates. And greater diversity in mortgage terms could, in theory, make the overall market for lending more stable, according to a new report issued Tuesday by C.D. Howe.
But spurring any meaningful rise in demand would require difficult changes to laws and regulations that have sapped the popularity of long-term mortgages in Canada, the report said.
The dominance of the five-year mortgage term “is too well-entrenched to be overcome organically without incentives or changes to laws or government policies and programs to encourage this development,” said Michael K. Feldman, a partner at law firm Torys LLP who wrote the C.D. Howe report.
One way to spur demand would be to relax a stress test, introduced in 2016 and expanded in 2018, that forces lenders to make sure borrowers could handle an increase of two percentage points in their mortgage interest rate at renewal. Since longer-term mortgages already carry higher interest rates, the government could set the stress test for 10-year mortgages at one percentage point or less, easing the burden to qualify, the report says.
Federal Finance Minister Bill Morneau has been tasked with considering ways to tweak the mortgage stress test, which has attracted criticism from mortgage professionals and would-be homeowners who see it as onerous and inflexible. But the government will want to avoid any change that could increase risky borrowing, as household debt levels are already high.
Relaxing the stress test also wouldn’t address the root cause of Canada’s preference for shorter mortgage terms, which lies in the Interest Act, a law passed in 1880. Section 10 of the act limits the penalty a borrower pays for breaking a mortgage after five years to three months’ interest. As a result, banks prefer to renew mortgages at least every five years, which resets the clock on prepayment penalties.
Most mortgage lenders also charge much higher rates on 10-year mortgages, to offset the financial risks from customers breaking loans early.
Interest rates on 10-year mortgages at Canada’s largest banks are about 0.5 to 0.7 percentage points higher than their five-year fixed rates. But a few lenders have more aggressive pricing, such as HSBC Canada, which offers a fixed 10-year mortgage at 2.99 per cent, compared with 2.79 per cent over five years.
“The bottom line is this: Consumers want 10-year fixed mortgages, but they don’t want to pay for the premium to get them," said Rob McLister, a mortgage broker and founder of the website RateSpy.com. "And the people selling them don’t want to sell them.”
If the limit on prepayment charges in the act was extended to 10 years instead of five, “it would greatly reduce the premium that a lender would have to charge” on longer mortgages, which “would be expected to lead to more 10-year mortgages,” Mr. Feldman writes in his report.
But such a change could be problematic: Borrowers who break their mortgages early would bear the cost, often paying much higher prepayment charges.
Instead, Mr. Feldman suggests that Section 10 could be tweaked to allow a short window of 30 days every five years when a borrower could break their mortgage with minimal penalties, reducing the risk of lost interest for lenders after five years.
Either way, if the federal government changes the act, most provinces have similar laws that would need to be amended one by one.
There are also ways to create more flexible funding for longer-term mortgages. Canada’s banking regulator, the Office of the Superintendent of Financial Institutions, could raise the cap that limits banks’ use of covered bonds, which are a source of funding to back uninsured mortgages. And Mr. Poloz has called for the development of a private market for residential mortgage-backed securities.
Without new incentives, however, “lenders do not currently seem to be eager to change the status quo,” Mr. Feldman said.
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