New Mortgage Rules:
Major Impact or Much Ado About Nothing?
One year ago today, Canadians were worried about the greatest recession since the great depression. Housing values would drop so low we will all lose our life savings. Everything was doom and gloom.
What a difference a year makes. No only did the housing market rebound – it came roaring back with a vengeance as if the recession had never occurred. So much so, in fact that at the end of December Canada’s Finance Minister Jim Flaherty did an interview with CTV in which he expressed concern over the sharp rise in housing values and fears of a pending housing bubble. He made it clear that the government had tools at their disposal other than tinkering with interest rates that could be used if necessary to slow down an ‘over-heated’ housing market. The tools he was referring to were changing the maximum amortization for 35 years down to 25, and changing the minimum down payment for CMHC insured mortgages from 5% to 10%. At the time many economists expressed concerns that an over-reaction to the current market conditions would dampen the overall economy and hinder our economic recovery. They warned the government not to over-correct a ‘hypothetical problem’ in reaction to ‘unwarranted fears’.
On the other hand, there were many voices in the market sounding the alarm – ‘Have we not learned from lessons of one year ago?’ Many felt that Canadians were getting right back into the same trap of using their homes like an ATM machine and were setting themselves up for disaster the moment interest rates start to rise. Surely the only prudent thing to do would be for the government to step in and protect us from ourselves – not to mention those greedy bankers who are once again offering us borrowing options that allow us to borrow with reckless abandon – at least that’s what some would have us think.
So what’s the truth? Well as always it lies somewhere in the middle. The fact is, interest rates must rise – not if, but when and by how much how fast. When this happens will a large percentage of Canadian homeowners be caught in variable rate mortgages paying only 2% interest only to find that their interest rate is now 5%. If that were to happen, would a larger percentage of those homeowners be in the position of no longer being able to pay for their mortgage. Would this trigger a mass sell off, thus resulting in an imbalance of the supply and demand equation, ultimately resulting in plunging home values – thus triggering the aforementioned dreaded ‘burst of the housing bubble?’
A fair question and one that many were asking and the government felt compelled to address. The result – the February 17th announcement of 3 new rule changes to government insured mortgages (read CMHC) aimed specifically at addressing these concerns. But the real question is; did they address legitimate concerns or was it simply a case of paying lip service to a vocal minority for the sake of good optics?
Let’s take a look at the three rule changes and analyze what they really mean to you:
Any borrower who chooses a short-term mortgage (1 – 3 years or a VRM) must now qualify at the 5 year rate in order to get a CMHC insured mortgage.
Negligible: the fact is that most lenders already require that anyone taking a variable rate mortgage must qualify at the ’3 year posted rate’. What’s of interest is that the government announcement did not distinguish whether the 5 year rate is a a’posted rate’ or ‘discounted rate’. The difference is about 1.5%. The irony is that the current 3 year posted rate is higher than the 5 year discounted rate, so if the government rule requires that you qualify at the 5 year discounted rate, this could actually serve to ‘relax’ the rule not strengthen it. In addition to that, recent surveys indicate that as much as 70%of Canadians already choose fix rate long-term mortgages.
Great move regardless. It is practical and imperative that anyone taking a variable rate mortgage today factor in a 3% increase in rates over the next 2 to 3 years. I still believe there are huge savings to be had if you take a variable today, but only if you increase your current payments to match the current discounted 5 year rate. In dong so, you will accomplish two things:
- You will accelerate the rate at which you pay off your mortgage, thus reducing your principal mortgage balance at the time of renewal. This will help to negate the impact of an increase in rates at that time.
- You will adjust your family budget today to the inevitable higher rates in the future – thus avoiding ‘payment shock’ to your budget.
Smart and prudent – but will it achieve the effect of helping to cool off the housing market and slow things down? Not at all – this one is purely optics.
The maximum amount you can refinance your home has been lowered from 95% to 90%.
Again this one is negligible. Smart move by the government to make mandatory what should be common sense. The only reason anyone would leverage their residence up to 95% would be to pay off high interest credit card debt with the extremely low interest mortgage debt. Others may want to simply access as much money as they can at these historically low rates in hopes of generating a greater return in the market. Either way, it is extremely imprudent for anyone to over leverage their principal residence. Whether there is a bubble or not, it certainly doesn’t take much of a market correction to eliminate 5% in the value of any home. For the average Canadian, their home represents their greatest investment and with that, their largest source of net worth. It also represents a major component of the average Canadians’ retirement plan. It should be a source of ‘equity development’ and not be used as an ATM to subsidize current lifestyle.
Smart and Prudent move. Will it have the desired effect of slowing down the housing market? Not at all. The truth is that the percentage of Canadians refinancing to that extent is an extremely small percentage of the population so this will have a very small impact.
The minimum down payment on non-owner occupied properties purchased for speculation will now be 20%.
Significant: this is by far the most significant of the new rule changes. Although the announcement specifically stated that they were targeting the ‘speculator’ not the ‘investor’, the net effect is that all investors will be impacted. However – and this is VERY important. The impact will not be the fact that investors must now put 20% down. The truth is, I’ve been teaching that for years. Any investor should look to put 20% down for cash flow reasons if nothing else. But the real reason this is a major rule change is the sub-text to this rule change that was not included in the original announcement and not reported in the press. In addition to no longer allowing high ratio mortgages, CMHC has also changed their underwriting policy. Whereas they previously allowed for an 80% offset of an investors existing portfolio when underwriting a mortgage, they will now revert to a 50% addback. Now to the average Canadian this is a meaningless change. But to the real estate investor, the change is significant. It will create 3 major changes:
- A 50% add-back is significantly less favourable to an investor than an 80% offset. Without going into an elaborate explanation of the difference between the two, let me make it simple: if you currently own more than three rental properties, you will never be able to qualify for a mortgage using only 50% of the rental income from your portfolio.
- No problem you say – I’ll just put 20% down. Well the secondary issue here is that all the non-institutional lenders such as Merix, Street Capital and DLC Mortgages, are MBS lenders and require that all the mortgages in their portfolio be insured – even if they are conventional (20% down). That means they need to follow the CMHC guidelines. This means those lenders are no longer an option for real estate investors with 3 or more properties even with 20% down payment.
- This will shift more of this business to the chartered banks, all of which are tightening their guidelines on rental properties meaning the next issue investors will face is ‘Cap space’. You will have a cap on how many mortgages you can get with each bank and you now have fewer choices. This will make the need to have a strategic plan even greater.
Significant impact on investors. But as for cooling down the overall market – again negligible, simply because real estate investors at the end of the day represent less than 5% of the overall market so their impact on the overall housing market in Canada is muted.
At the end of the day, the finance minister walked a thin line between addressing concerns about an over-heated real estate market in Canada and not over-correcting the problem at the risk of causing damage to the overall economy. I think he went too far with the changes to the investment side, but otherwise I give him full marks. By addressing these concerns now, it should also take pressure off Mark Carney and the Bank of Canada to raise rates prematurely and that is in the best interest of our overall economy. But like I said in January – it’s the government we’re talking about – anything can happen.
Until next time;