March 31st, 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

29 thoughts on “Qualifying for Higher Payments…In Advance”

  1. Great post as usual Rob Long term affordability is critical to succesful homeownership and when rates will rise and by how much is anyone’s guess but of course will effect all borrowings not just the mortgage. Unfortunately a lot of consumers don’t take into account the many unforeseen life events and unexpected expenses that cause many to have financial challenges after they buy or refinance their homes. Qualifying guidelines use gross incomes and a lot of expenses that families have such as day care and cost of operating two autos are not taken into accunt. Mortgage professionals can further differentiate themselves from the banks by educating their clients with a long term plan to mitigate increaes in rates on all their debts beyond just the mortgage so the client can enjoy their home in the long term.

  2. The good news is that the risk groups described above are the minority.
    How does this matter? Prices are set at the margin. On the way up in seller’s markets, prices are bid up by those willing to overpay and overleverage. On the way down, inventory is dumped by forced sellers with little equity and cash flow problems. As the US started to melt, we heard the High Priests spend two years telling everyone that problems were “contained” to the subprime market. Hey, most borrowers were prime, and most of THEM had fixed 15 or 30 year terms, with NO renewal risk (a difference never highlighted by those who explain how the US market differed from Canada’s!)
    We’ve written voluminously about how unnecessary lending regulations penalize strong borrowers.
    And how! But these regulations only apply to regulated lenders whose deposits and mortgages are insured. Nobody’s stopping YOU from lending money to these “strong borrowers” Rob, they’re just saying that the Canadian taxpayer won’t backstop, via CMHC and CDIC, the high-ratio mortgages you feel they deserve. How is someone who wants to use minimal amounts of their own money and post no collateral other than the property a “strong borrower”? When things get tough, that guy is a “weak hand,” especially when he’s sitting on a property that wouldn’t cash flow if rented. The Five C’s of credit haven’t changed.

  3. Another oustanding article Rob.
    If I can offer one piece of advice to mortgagors it would be to increase their mortgage payments as much as possible. Even a simple move to bi-weekly payments instead of monthly can make a real difference.
    The point being that if a mortgagor purposely puts themselves on an accelerated payment schedule and interest rates rise, mortgage payments can quite often stay the same. Voilà, no cash-flow problems.
    Quite often the best defence is a good offence.

  4. “We’ve written voluminously about how unnecessary lending regulations penalize strong borrowers.”
    What about private and pension funds who are losing money because the BoC and Fed have been buying/repo-ing government and covered bonds to keep borrowing costs low? Why should pensioners’ returns on their life savings be penalized to keep a speculative housing market afloat, when it’s going to crash anyways?
    http://i44.tinypic.com/28k802a.png
    http://i41.tinypic.com/2dbv6gg.png
    I’m convinced, brokers really do believe money grows on trees.

  5. Ralph,
    It matters because a limited amount of forced selling entails less risk than a large amount of forced selling. There is plenty of data out there that quantifies the risk group. This article touches on two of numerous such statistics. The archives have many stories with others.
    Regarding your last point, it’s not about me Ralph but thanks for making it personal. :)
    It’s about responsible borrowers having access to reasonable mortgage flexibility, and about determining where the arbitrary line in the sand is draw on things like amortization. You clearly have your opinion of where that line should be. This forum is provided for your benefit to voice that opinion. Other respected observers would have a different position.
    The topic of restricting mortgage flexibility has played out in these message boards for years. It still boils down to two factors: a) what economic benefit accrues to prudent mortgagors and the economy at large, and b) what material risk is added to the system, if any.
    Of all the mortgage issues to worry about, however, the last area of concern should be the borrower with a 720+ Beacon, sensible debt ratio, strong repayment history, 6+ months of liquid assets, equity from their own resources, positive net worth, etc. who chooses a feature like the extended amortization to meet her financial goals.

  6. Thanks Appraiser. Great point. And for those who don’t have a big enough contingency fund, parking the payment difference in a TFSA is often another practical option.
    Cheers…

  7. And if that borrower has 20% in the deal, there’s no restrictions. You’re advocating for her having only 5 or 10% in, and an amortization that ends when she’s 75, on a property that likely wouldn’t cash flow with a 25 year am (and maybe not even with a 30). At some point, this isn’t a low risk loan, even if she does bring a good current income and score to the table.
    As valuable as mortgage brokers and property developers are, it’s obvious that we can’t increase our national wealth if we’re all just building and selling each other houses. It’s my contention that a too-great fraction of the economy is currently involved in the housing sector. Allowing people with good scores and reasonable incomes to take out large, long-am credit-enhanced loans with small DPs has been driving this misallocation of resources.
    What exactly do you mean when you say such borrowers should be allowed such loans “to meet [their] financial goals”? Nobody’s goal is to not have the house paid off until they’re 75, or to pay more interest. Does it mean to swing a maximum investment with minimal capital? To buy a larger house than she could afford with a more conventional amortization and DP? To reinvest the capital she’d otherwise have to tie up in the deal? To make a rental pencil that otherwise wouldn’t cash flow? It isn’t that such a person doesn’t have access to capital but, absent a government guarantee, lenders would demand more of her equity in the deal, a higher rate, shorter am, or more realistic cash flow. This is a bad thing?

  8. @Cramdown
    When you use the U.S. sub-prime experience to make your point about risk in Canada’s mortgage market, it makes you look like a desperate extremist.
    The size of the US and Canadian sub-prime markets, the securitization differences and the incomparable underwriting standards don’t even justify the analogy. It’s a fallacious comparison and you will never earn respect for your views by drawing such parallels.

  9. Ralph
    You’re on to something man. There is no way we should have amortizations over 10 years in this country. We in Toronto can learn to live in 150 square foot condos.

  10. I’ve often wondered about this — especially day-care. The cost of full-time day-care in central Toronto for a one-year-old can easily be $1,300-$1,500 per month, comparable to the mortgage payment on a condo or starter home.
    Seems to me that a realistic appraisal of a young couple’s ability to afford a mortgage, if they plan to have kids, would have to take the cost of day-care into account as a 3-year financial obligation. Either that or they should be qualified based on a stay-at-home parent scenario.

  11. The question you have to ask yourself is: If Canada’s homeownership rate, debt to income and median family income:median home price are all comparable to the USA’s circa 2005, how is it that their subprime market was huge and ours is tiny? I’ll grant you that their income distribution, as measured by GINI, is somewhat more skewed than ours, but I don’t think that’s enough to explain the difference, factoring out that the poorest 30% don’t count anyway.
    It’s different here than it was in the US, the UK, Ireland, Spain, and here before the last bust?

  12. Why won’t the big banks lend at 35/40 year amortizations? There’s no regulation stopping them, for borrowers with 20% down. Oddly, when CMHC stopped insuring 40s, they stopped writing 40s, even prime, low LTV 40s.

  13. Dismissing the US experience completely, as if there’s nothing Canada could possibly learn from it, also smacks of desperation.
    I think Ralph’s point still stands — that even if a small minority of borrowers get into trouble (such as the 20% of mortgage holders who would be troubled by a 2% increase in rates) it will be their choices that set prices in the market.

  14. Ralph,
    Always happy to engage in worthwhile policy debates. The exception is when words are put in my mouth as to what I’m advocating.
    Nobody is promoting debt into retirement. All that’s being said is that well-qualified borrowers require the freedom to allocate income to other valid uses…besides their mortgage.
    Those uses may include, but are not limited to, educational expenses, medical expenses, child care, building a business, value-added renovations, bolstering contingency funds, investments for retirement, etc. etc. Homeowners can then prepay their mortgage when the time is right for them—which in turn can significantly reduce their effective amortization.
    Call it radical, but we happen to believe that responsible homeowners know how to manage their finances better than the government. And to the extent that Canadian families don’t add undue risk to the system, they should be given maximum latitude to do so.
    All the best…

  15. There is a tricky balancing act going on here. It’s not just about mortgage regs and lending policy issues although they are clearly important. Super cheap money over a long period of time is an overwhelming factor, it distorts our whole business.
    While Watchdog’s endless screed is boring and pedantic there is a kernal of truth, the super low rates are not natural and the fact there seems to be no end in sight for them pushes lending practises and property values into an unsustainable lock-step.
    I talked to a renovator today who is incredibly busy; he told me every job he was doing is a result of families tapping a HELOC. The property values go up, the consumer taps his HELOC for more funds and the property values keep moving up on a tide of “show kitchens” and fully finished basements for a family of three????
    However as Rob points out in another good and timely article: how is penalizing a strong borrower with overwhelming regulations inately “right”? How does tinkering with the five percent down regs for new homeowners “fair” when the current program’s been going on sucessfully for 30 years? We enjoyed those benefits; why is okay to change the game now?
    Perhaps we just have to let the marketplace play this out. It will eventually correct itself with or without changing lending policies.

  16. The thing is, we’re already talking about somewhat-less-than-well-qualified borrowers here. People with all of the 5 C’s, including a 20% DP, are free to borrow without a (CMHC) cosigner. People with 4 out of 5 can borrow too, just not from a federally guaranteed lender, unless they meet CMHC/OSFI terms. A low DP coupled with a long amortization means the homeowner may have little to no equity for a number of years. I think low/negative equity is the #2 risk for default, after unemployment. So it isn’t unreasonable for the cosigner to be especially wary of those deals.
    This is the credit tightening cycle. So far, they’re only tinkering at the margins, so only the marginally qualified are affected. I don’t think it’s unreasonable for the guarantor to call the tune.
    Thanks for your responses.

  17. If/when the market does correct, though, there’s going to be an awful lot of bagholders, including all those low DP/long am first-timers who’ve been led to believe that paying 5+ times income for a home is normal, all those renovators who were burning through others’ HELOCs, and a lot of ancillary trades and services. It won’t be pretty. This boil has gotten so big that everyone’s loth to lance it, but Ottawa understandably doesn’t want any financial institutions collapsing, either, or to have to write a ten-figure cheque to the CMHC. “Please, Lord, not on my watch!” – the motto of financial regulators everywhere.

  18. Screed it may be, but at least I render factual information rather then pulling numbers from the sky and making incomparable claims.
    Toronto listings 35 years ago.
    http://i41.tinypic.com/20tqueq.png
    http://i42.tinypic.com/jipbtw.png
    Rates 35 years ago.
    http://i39.tinypic.com/2j29fk2.png
    http://i43.tinypic.com/w1fnls.png
    Remember those days when interest was paid on savings to maintain purchasing power with inflation?
    At what point does the obvious become the obvious? When will people finally realize (and discuss) that the BoC is posturing because they’ve checkmated themselves? Many are conditioned to believe the BoC has more tools at its disposal, but as the rate chart above shows, what has worked for the past three decades isn’t available any more.
    When you can quantify the data, you’ll realize there is nothing other then a dire outcome. It just math you can’t win against.

  19. Cramdown who the **** are you to say who gets to borrow from who?
    I’m guessing just about everyone here has had enough of you playing God of the mortgage universe.

  20. Ralph, the simple truth is that in any correction there are bag holders. It’s like gravity, there is no point in trying to stop it. I am not that worried about CMHC at the end of the day they are an insurance company and the operating principal of every insurance company is charge more premium and pay less claims. If worse comes to worse they will just find ways to pay fewer claims and they will survive just fine.

  21. 20% of homeowners think they would be in financial distress if mortgage rates increased 2% and yet in Canada at least, banks know that most homeowners in such situations curtail spending, beg, borrow, sell and sometimes even steal to keep their mortgages current. Banks/F.I.’s clearly understand and measure the phycology of this!
    Ask yourself, what percentage of households would be in financial distress if they experienced divorce, job loss, temporary layoff, disability, health or addiction problems to name a few?
    Put into context, it’s easy to surmise that many of the above comments are alarmism responses better served elsewhere.

  22. divorce, job loss, temporary layoff, disability, health or addiction problems
    Those are problems that affect a relatively small and constant % of people each year, with the economy affecting numbers somewhat.
    A 2% interest rate hike affects >20% of fixed, all variable holders and all first-timers in the year it happens, and more in every subsequent year. On the upside, rate hikes mean the economy’s doing well, so maybe they’ll be richer than they think.

  23. Those are real life examples of relevant issues that cause families to lose or be forced to sell their homes. A 2% rate hike unto itself, is not.

  24. How about having to spend an extra 20% on taxes!
    Offshore Employment Tax Credit Phase Out
    I am a Hydrographic Surveyor with specialties in the area of submarine telecommunication cables and power cable installation. At the moment the struggle for work is more difficult as there are now many countries supplying surveyors at very low rates (mainly Malaysia, where the cost of living is very low compared to Canada). To remain competitive we have had to hold back and or lower our rates. Our only advantage has been the tax credit.
    It seems backward thinking to force so many offshore workers to have to quit their jobs and be retrained. Also the amount of money we having been bringing into Canada and spending here is not insubstantial. 

  25. It depends on how small the “small minority” is. There could also be offsetting factors that support the market. I think it’s silly to pretend we’re smart enough to know what the outcome will be.

  26. Another irrelevant comment with irrelevant links. WTF do Fed repos and pension funds have to do with lending regulations? You’re great at seeing patterns in randomness Watchdog. Some would call that delusional.

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