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decoding the mortgage market

Canadian Mortgage Trends editor Robert McLister's fourth column for The Globe's month-long Home Buying site looks at housing affordability.

If you had to earn a living predicting home prices and could use just one indicator to do it, which would you choose?

I asked two top economists that question. Their answer was the same: housing affordability.

"Affordability is a key variable. It gives you a lot of information," says CIBC deputy chief economist Benjamin Tal. "When affordability is good, demand usually exceeds supply."

Affordability – a type of debt service ratio – gauges the average percentage of income needed to carry a mortgage. This is closely linked to how much homeowners can borrow.

It's a rather paradoxical statistic. You would think, for instance, that with home prices doubling in the last 10 years, affordability would be getting worse.

Actually, national affordability is almost the same or better than 20 years ago, according to measures by the Bank of Canada and major economists.

For that, we can thank both falling interest rates and rising incomes. Discounted mortgage rates, for example, have dropped more than five percentage points in the last 20 years.

"Mortgage rates have been extremely important in affecting affordability and demand," says Mr. Tal. "Affordability (today) is a commentary on the effects of low rates."

But with soaring debt levels, doesn't it seem counter-intuitive that folks could "afford" such elevated home prices? It might, but affordability doesn't measure home prices or total debt.

It measures, albeit crudely, how "easy" it is to make the payments. And payment tolerance is a main concern of people looking to buy. (I say "crudely" because nationwide mathematical measures say nothing about an individual's ability to afford a mortgage.)

Low rates have been pivotal for consumers. They've kept interest payments, as a share of disposable income, at just 7.2 per cent, Mr. Tal says. That is below the long-term average of 7.6 per cent and well under the 10.7 per cent level from 20 years ago.

Cheap rates have also supported bigger mortgages. If we look at mortgage payments from two decades ago, a typical single job holder with 10 per cent down and minimal consumer debt qualified for a $96,000 mortgage.

Today, he or she could get a $285,000 mortgage - almost three times as much.

(This assumes a 25-year amortization and standard lender assumptions for debt ratios, property taxes and heating costs. It uses Statistics Canada data for wages and estimates of five-year fixed mortgage rates based on Bank of Canada data.)

That might be little consolation to folks living in places like Vancouver or Toronto, which are exceptions to affordability. But the fact remains that overall, low rates give borrowers tremendous leverage.

Leverage is something the Bank of Canada is understandably concerned about. Cheap money means "cheap" debt payments, and it's awfully easy to get complacent.

When rates do eventually take the elevator up, real estate is going to feel it.

House prices will "almost certainly" roll over when interest rates rise, BMO senior economist Sal Guatieri said in a recent report.

"A 2 per cent rate increase would put enough strain on affordability to slow the market meaningfully," he said. "It would encourage many first-time buyers to just rent."

That 2 per cent number has been coming up a lot. Research from BMO and the Canadian Association of Accredited Mortgage Professionals shows that one in five Canadians believe a 2 per cent rate increase would jeopardize their ability to afford their home.

But mortgage costs are just one part of the equation. Incomes also matter. In the three years since the financial crisis, annual earnings have grown roughly 2.5 per cent on average. It is conceivable that rising wages could absorb the blow of higher rates, but rates would have to climb much slower than they have in the past.

Income aside, there is one other event that would certainly counteract a drop in affordability: a drop in home prices.

Other things equal, a greater-than-16-per-cent fall in national home prices would cancel out the affordability damage of a 2 percentage point rate hike. Although most people don't expect that kind of selloff on a national basis, home prices will be something to watch.

Housing weakness could also be exacerbated by the government. Regulators are currently planning new federal lending guidelines that would make it tougher to get approved for a mortgage. These measures will impact housing demand, to some degree.

Proposals being considered could require banks and federal trust companies to:

  • Make borrowers prove they can afford higher rates, even if they have large down payments
  • Eliminate cash-back down payment mortgages (effectively 100 per cent financing)
  • Make self-employed borrowers show more proof of income
  • Restrict use of interest-only secured lines of credit
  • Use more conservative debt ratio tests

If adopted, these rules would provide another threat to affordability, until prices and other factors catch up. According to this Globe and Mail story, some or all of these lending guidelines could be finalized as early as this summer.

If home prices keep rising, there's also a chance we could see maximum amortizations on insured mortgages cut from 30 to 25 years. This would slash affordability for first-time buyers by 8-9 per cent overnight.

The takeaway here is simple. Mortgage payments, as a percentage of income, will be a critical harbinger of home prices.

Mortgage carrying costs are not the only factor – you have to consider supply and a host of other demand drivers. But on a stand-alone basis, the importance of affordability trumps any other single variable, including employment, GDP, immigration and household formation.

Mark Carney and the Bank of Canada will be acutely aware of this when they eventually ponder how high to take rates.

Robert McLister is the editor of and a mortgage planner at Mortgage Architects. You can also follow him on twitter at @CdnMortgageNews.

For tips, stories, videos and live chats about what's going on in the real estate market, check out the Globe's Home Buying section for daily updates.