The 5-year Funnel

Take all the high-ratio borrowers with above-average debt ratios and funnel them into 5-year fixed terms.

That’s what the government has done with its new posted qualifying rate.

The instinctive conclusion after hearing about posted qualifying rates is that droves of people will no longer be able to qualify for a mortgage. 

Not so.  Posted qualifying rates won’t keep the masses from buying homes. 

To illustrate this, pretend you live in the typical Canadian household which makes about $66,343 a year. Perhaps your family has $500 a month in non-housing debt obligations. How much mortgage can you afford?

Well, maybe your name is ‘Mr. Leveraged’ and you want to stretch your budget. You can get yourself qualified today using a 3-year fixed rate of, say, 3.49%. That’ll get you a $314,000 mortgage, or thereabouts.*

If the new qualifying rules were in effect today, you’d get more buying power with a 5-year fixed mortgage. That’s because variable-rate mortgages and 1- to 4-year fixed terms would (will) require you to qualify using a 5-year posted rate. Posted is 5.39% today.

The qualifying rate on a 5-year fixed mortgage, however, might only be 3.75% (and even less with some lenders).

Having to qualify with 3.75% instead of 3.49% would knock Mr. Leveraged’s maximum mortgage down to $304,000.  That’s a mere $10,000 less than he can get under today’s qualifying rules (which still apply until April 18, 2010).

This small loss in buying power isn’t that big a deal.  The government’s new qualifying rate policy will not be an obstacle to people buying homes.

What it does, however, is funnel people with higher debt ratios and less equity into 5-year fixed mortgages.

Who’s happy about that?

• Big Lenders:  Because 5-year fixed terms are usually more profitable than variables or shorter terms.
• Bankers and Mortgage Professionals:  Because they often get paid more up front for selling 5-year fixed mortgages as opposed to shorter terms.
• Many Others:  Because 5-year fixed terms help:  1) Keep high-ratio applicants with less equity from overextending themselves; and, 2) reduce payment shock as interest rates start climbing.

Who’s not happy?

• Qualified Homeowners Without 20% equity:  Because many of them will no longer be approved for lower-cost variable-rate mortgages, 1- to 4-year fixed terms, or hybrid mortgages.
• Smaller Non-Bank “A” Lenders:  Because it’s harder to compete with big banks in the prime 5-year fixed market.

A final reminder for good measure: The new posted qualifying rate will not apply to all mortgages. CMHC says it will apply after April 19 only to insured mortgages with less than 20% down.

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* The maximum mortgages were calculated assuming a 35-year amortization, 5% down, 680+ credit score, 44% maximum TDS, a 1% property tax rate, $100/month for heat, and a 3.15% default insurance premium. Median income source: 2006 census.