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« 1 in 5 Challenged by 2% Higher Rates: BMO | Main | Choices Shrinking for 35-Year Amortizations »

March 31, 2012

Qualifying for Higher Payments...In Advance

140276734Someday, when many least expect it, inflation risk will drive up interest rates, and they’ll go up for more than just a few quarters.

When that finally happens, two things will impact how some homeowners’ adapt to higher payments: the velocity of rate hikes and the degree of income growth in the economy.

Our story in today’s Financial Post (Mortgage affordability depends on…) weighs in on those two factors and ponders some effects of a 2% rate increase.

One of the takeaways is that most mortgagors could easily handle that kind of rate-bump. Some, however (20% according to CAAMP and BMO surveys), would have a far tougher time.

It's that latter group that regulators had in mind when they instituted a precautionary measure called the “benchmark qualifying rate.” 

The benchmark rate came along two years ago. Its purpose was to help ensure that borrowers could afford their mortgage payments when rates rise. And, generally speaking, it does an okay job of that. 

But it's far from foolproof. For example:

  • Insured borrowers who choose a variable or 1- to 4-year fixed term must currently prove their ability to afford payments at the 5-year posted rate. That rate is 5.24% as we write this. But:
    • Most lenders don’t require that same test for uninsured borrowers (those with 20%+ equity). Those borrowers are tested at a lower hurdle, like the 3-year fixed rate. 
    • The thinking is that there’s enough value in the property to discourage default and recoup losses in a liquidation scenario. 
    • That is true the vast majority of the time, but not always.
  • Benchmark qualifying rates do not apply if you choose a standard fixed term of five years or more.
    • People taking 5-year mortgages only need to qualify at the offered rate (aka, “contract rate”). At 2.98% to 3.19%, recent contract rates have been just a hair above most variable rates.
    • If rates rose 2%, however, payments on a thirty-year $200,000 mortgage at 3.19% would jump 22.6%. There is currently no test to ensure a 5-year borrower can bear that kind of increase at renewal.
  • Qualifying rates don’t control the debt that people incur after getting a mortgage.
    • It’s not unheard of for folks to buy a new car or take on other big-ticket or revolving debt right after their mortgage closes. Many people are knowledgeable enough to apply for that credit after closing, so as not to jeopardize their approval.
    • Once a mortgage is in place, it can become all too easy to get comfortable with the low-low payments, and ramp up discretionary spending further.
    • Doing this raises peoples' debt ratios, of course, and makes a minority of borrowers less able to withstand higher rates.
  • Unexpectedly rapid price increase (for things like gas, utilities, taxes, etc.) or “underemployment” (having to take a lower paying job) can further diminish a leveraged borrower's cash flow. This, in turn, encourages additional debt accumulation and traps some in a coiling debt cycle.

The Positive

The good news is that the risk groups described above are the minority. Most borrowers will be nowhere near the affordability danger zone when rates increase 2%. The average mortgage holder’s total debt service ratio was just 29% at last count, according to CAAMP. The traditional maximum is 40%, and lenders allow up to 44-45% for more qualified applicants.

Additionally, CAAMP estimates that less than 1% of borrowers would have a TDS ratio north of 45% if variable rates rose 2.50%.

The Likely Result

Despite that, it’s possible that regulators will tighten qualification rates anyway, potentially within 6-12 months. New OSFI guidelines, for example, might impose qualifying rates on all borrowers, including on conventional mortgages.

Some observers, like TD’s chief economist Craig Alexander, propose a general minimum qualification rate. That rate could be set at something like 2.50% above prime (5.50% today). It would then be part of an income test applied to all applicants, regardless of default insurance, their mortgage term, amortization, or rate type.

Sensibility

Of all the mortgage regulations that could be enacted, this one seems most practical. We’ve written voluminously about how unnecessary lending regulations penalize strong borrowers. They do that by taking away economically-important mortgage options from people that don't add risk to the system.

Stronger qualification rate guidelines are different. They are warranted safeguards because they can be applied to everyone without unreasonable repercussions.

At the end of the day, homeownership can be a lot of fun. But, it comes with a degree of financial risk and plenty of expenses, of which many are unforeseen. When it’s most fun, however, is when you don’t have that nagging seed of doubt about affording your payments.


Rob McLister, CMT


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