Canada's banking watchdog seems intent on stamping more risk out of the mortgage market.
The latest idea being floated by The Office of the Superintendent of Financial Institutions (OSFI) is to limit amortizations to 25 years for homeowners who have put down 20 per cent of the purchase price or more. The current maximum is 35 years.
If this rule is enacted, OSFI would be targeting a minority of borrowers. According to the latest data from the Canadian Association of Accredited Mortgage Professionals (CAAMP), of all the buyers from 2008 to 2012 who got a mortgage with over 20 per cent equity, 24 per cent chose an amortization of more than 25 years.
Skeptics contend that long amortizations are used mostly to shoehorn over-leveraged borrowers into homes they can't afford. A 2012 Altus group study contradicts that. Only one in five purchasers said they chose extended amortizations because: "This was the only way I could qualify for a mortgage." And only a minority of those 20 per cent would be at risk of missed payments.
In my experience, conventional borrowers most often use 26– to 35-year amortizations for cash management purposes. These people could readily afford a 25-year mortgage but prefer the payment flexibility of a longer amortization.
Without question, some long-amortization borrowers blow their payment savings on consumables. That's their prerogative. But many others are productive with these extra funds, using them to:
- Invest in higher-returning assets
- Pay down higher-interest debt
- Fund education or childcare expenses
- Provide supplementary cash flow while on maternity leave
- Top up RRSPs
- Pad a contingency fund (especially useful for commission earners with volatile income)
- Invest in their own businesses
- Pay medical expenses
- Finance value-added renovations or preventative-maintenance projects
- Maximizing income property cash flow
- Provide payment relief in case rates soar by the time they renew
In all of the above scenarios, borrowers taking 30– to 35-year mortgages can make extra payments to trim their effective amortization. And that's exactly what many do.
In 2011, for example, a CAAMP survey found that borrowers paid off their mortgages in just two-thirds of their original amortization. Extended amortizations haven't been around that long but there's every reason to believe people will also pay them down ahead of schedule. In fact, those choosing 35-year mortgages predicted they'd be mortgage-free in just 24.7 years on average, according to the survey.
It's unknown how regulators came up with the idea to limit conventional mortgage amortizations. Some speculate it's to reduce overall leverage in the banks' mortgage portfolios. Others think the Finance Department is looking for new ways to cool housing activity – since record home prices are interfering with its plan to induce a "soft-landing."
Either way, added amortization restrictions would weigh further on Canadian real estate. I asked CAAMP economist Will Dunning for his take on how much. Here's what he said: "Would an OSFI ban on extended amortizations reduce home sales? Yes. But can we quantify the impact? No."
For what it's worth, I've heard ballpark estimates that the move could cut home sales by at least 5 per cent, and that's probably not significantly off. But is adding another housing barrier advisable in the face of already flagging homes sales, mortgage volume and housing starts? That question may be academic if policy-makers have already decided to act on this issue, which they sometimes do despite plans to consult the public.
Keep in mind that most mortgages with at least 20 per cent down (a.k.a. "conventional mortgages") are uninsured. Lenders take virtually all the risk, which means taxpayer exposure is negligible.
Moreover, homeowners with considerable equity on the line do not default in significant numbers. They find a way to pay their mortgage and preserve their net worth – and the roof over their head.
Even homeowners with interest-only home equity lines of credit (HELOCs), which have "unlimited" amortizations, default in miniscule numbers. Only 18 out of 10,000 credit line holders (this includes unsecured credit lines) are delinquent on their payments, says TransUnion. That's even fewer than the 0.33 per cent who are behind on their mortgages. (Note: HELOC delinquency rates are partly reduced because people can borrow from their own HELOC to make their minimum payments.)
Cutting back low-ratio amortizations is therefore not a major risk reducer. Someone with 20 per cent down and a 30-year amortization will amass almost 30 per cent equity when their first 5-year term renews (based on their original property value). That provides ample cushion if home prices tumble, and just 2.7 percentage points less equity than if they chose a traditional 25 year amortization.
Another factor to remember is that higher interest rates make it harder to get approved for a mortgage. If rates soar by renewal, people who must qualify with a 25-year amortization could be forced to renew with their existing lender, despite better terms elsewhere.
Of course, it's hard to defend someone using a long-amortization to buy a house they can barely afford. That's why some advocate making conventional mortgage applicants qualify at 25 years, while allowing them to set their actual payments based on a lengthier time-frame. Given the utility of longer amortizations, that's far more reasonable than killing them altogether.