Rising Rates And Mortgage Arrears

Percent growth Editorials have been overflowing lately with speculation on how rising rates may lead to a surge in mortgage defaults.

CIBC economist, Benjamin Tal, says history doesn’t support that premise.

In a report yesterday he wrote:

      “Mortgage arrears rates are highly correlated with the unemployment rate.”

  Mortgage arrears have “little or no correlation with changes in interest rates.”

(Perhaps this is why default rates peaked at only ~1% in 1982-83, despite 21%+ mortgage rates in 1981.)

  “Interest rates rise when the economy recovers…the benefits to employment and incomes of an improving economy easily offset the sting of higher interest rates on debt service costs.”

  The Bank of Canada (BoC) estimates that 5.9% of Canadian households are “vulnerable to rising interest rates, since their debt service ratio (DSR) exceeds 40%.” CIBC estimates the number at 4.0% because many of these homeowners still have significant home equity.

  Of the five million Canadian households with a mortgage, only 350,000 or so have a mortgage with a loan-to-value exceeding 80% and a debt service ratio greater than 40%.

  The BoC forecasts that the share of households with a 40%+ DSR would climb to 8.5% by 2012 if interest rates rise by 3%.  (Assuming they’re right, most would consider this increase manageable.)

Benjamin-TalDespite the “buffers” above, Tal says, “It is time for both borrowers and lenders to exercise prudence in continuing to build up household debt loads to the point where they are overly reliant on today’s low rates.”

To this we’d agree, and add:  There is no better time in history to pay off debt instead of rack it up.  Today’s 2.25% prime rate won’t last forever.  Rates this low are affording people a once-in-a-lifetime opportunity to pay off large amounts of debt principal.

  1. This may have been true in 1981, but I don’t think it is any more. The qualifying rules for mortgages were stricter then. You didn’t have so many people with 30+ year amortizations, who put only 5% (and in some cases less) down.
    I know many people (sadly) who can barely afford to make ends meet now. If their mortgage payment went up by a couple hundred dollars a month, they wouldn’t be able to afford to eat. And come time to renew the mortgage, they are carrying so much credit card debt, and have so little equity, that they may not qualify for another mortgage.

  2. When increases start what will happen to discounts off the bank’s posted rates?
    Historically how much have the discounts off the banks posted rate been and what influences them? Garth and I had an exchange about interest rates in his post he figures that after a possible initial hike by Carney by 1% next year 5-year fixed mortgages will be close to 7%.
    What scenario would reduce or eliminate discounting off the bank’s posted rate?
    http://www.greaterfool.ca/2009/12/16/act-one/

  3. Garth is like the Bible — you can find justification for just about everything somewhere in his posts. Predictions for inflation, deflation, booms & bubbles. The only think consistent about his predictions is that he keeps making them.

  4. “This may have been true in 1981, but I don’t think it is any more.” @Diane B
    Try inputting a 20% interest rate (hell, even a 15% rate) in a payment calculator. See for yourself how much it costs to service a mortgage at that rate. Then compare that to todays rates + 3%. BIG difference. Based on this simple test you can assume that defaults won’t be much higher when rates increase. Not with recovering employment and rates that are 1/3 of what they were in the 80s.
    Secondly, there were a lot of people back in the early 80’s putting down 10%. That is not exactly night and day better than 5%.
    Thirdly, you said you know “many people” with mortgages that can’t make ends meet. You must be referring to the 4% of Canadians with high debt ratios. The fact that you know so “many” of those 4% means you hang out with a poor socioeconomic crowd. That’s all I draw from your statement. Help your “4%-acquaintances” out. Tell them to sell and rent.
    chuck

  5. The report doesn’t mention anything about eventual fall in house prices and its impact (even though he mentions that the house prices in Canada is overvalued by about 7%). The assumption here is that house price will remain the same and people will continue to pay the mortgage even with the rising rates. We all know how that assumption played out in the US.

  6. At today’s low interest rate, a 3%-age point rate increase (say from 5% to 8%) implies a 32% increase in monthly payment, assuming 25-yr mortgage. On the other hand, a rate increase from 15% to 18% represents “only” a 18% payment increase. Thus, the impact of an interest rate increase is more severe at low interest rate.
    On the other hand, debt ratio doesn’t necessarily relate to income. There are studies that show high-income earners are cash-poor because they have equally high living expenses and heavy borrowing. Besides, I don’t think only 5.9% of Canadians are vulnerable to rate increase. A poll conducted several months ago say a large % of Canadians wouldn’t be able to make their mortgage payment if they don’t have income (e.g. got laid off ,etc.) for just one month. This shows the general lack of savings by Canadians.

  7. Gokou
    Your actual payment amount will jump 21% more if interest rates increase from 15% to 18%, even though the percentage differential only increased 17%. So even though at first glance it seems the percentages you quoted above are the better deal they are not. It actually better to be in the 5% to 8% interest rate jump camp because the actually payment goes up less.
    eg. $220k mortgage
    5% to 8% payment increase $399
    15% to 18% payment increase $484
    So even though the percentage differential from the lower to higher interest rate is higher the actual payment differential from the lower to higher interest rate is less.
    Just because it looks like a duck and quacks like a duck, doesn’t mean it really is a duck. Could just be a Gokou pretending to be a duck.
    PS: The market is the market… it will do what a market does, no one knows for sure what direction it’s headed… only that it will head in some direction.

  8. The storm is coming and it is going to be bad. We will emerge stronger in time but it will be painful for the foreseeable future. Unfortunately for me my mortgage is due for renewal in 12 months.

  9. Dabull
    You are using dollar amount comparison where I was using percentage comparison. Your comparison implicitly assumes that the person in example would apply for a $220k mortgage regardless the interest rate is 5% or 15%. This is likely not the case for first time buyers, who tend to go for the maximum mortgage they are eligible for. Regardless, a 3% interest rate shock still result in meaningful payment increase in either interest rate scenario for many borrowers.

  10. Quote.. “The assumption here is that house price will remain the same and people will continue to pay the mortgage even with the rising rates. We all know how that assumption played out in the US.”
    As much as housing bears don’t want to admit it, Canada is not the U.S. You can’t walk away from a mortgage here, and bankruptcy is no longer a walk in the park either. You can be damn well sure Canadians will pay their mortgages.
    Don’t forget, we also have a 180 degree difference in lending standards.

  11. Can Americans really “walk away from a mortgage”? I think its different from state to state, but basically you can’t get credit for a long period after you’ve done this.
    I’m not sure how this is any different in Canada. I know if you go bankrupt, it takes about 7 years before you can get credit again.
    So is there a difference in the penalties of foreclosure/bankruptcy between the US and Canada that I’m missing? I’d like to find a reference where I can read more on this.

  12. Dabull
    Ducks aside, I have to agree with Gokou. Creditors give out mortgages based on how much monthly cashflow borrowers can generate. The absolute amount isn’t as relevant as their ability to service the payments.
    Based on your example, if the borrower could only generate enough cashflow to support a 25-year $220K mortgage at 5% the monthly payment would be $3040. They probably wouldn’t qualify for the mortgage at 15% with a monthly payment of $6600. So an absolute comparison doesn’t make sense.
    Its the relative percentages that count. A 3% rate hike will be more challenging when you start in a low interest rate period.

  13. Hi ValueMonkey:
    I think your monthly payments might be a little off…
    A $220K/25yr/5% mortgage has a $1,279.53 payment. At 15% interest, it is $2,741.52.
    Naturally, 15% rates are a little “out there” because we’ll likely never see those rates again. The bank of Canada and federal government would use every weapon in their arsenal to prevent double-digit rates due to the economic consequences.
    So we’ll stick with a more likely scenario (e.g. 4% rising to 7%).
    One thing you need to do when stress-testing a borrower’s budget is to calculate the new payments at renewal by using the person’s lower balance at renewal. Taking your $220,000 mortgage as an example, the balance on a 4% loan would be $191,518 after 5 years. If rates rose to 7%, the payment would increase from $1157.24 to $1341.43. That is just $184 a month, which could be offset by income gains.
    Therefore, mortgage rates would have to go up significantly for mass numbers of people to get hurt at renewal.
    Anything is possible, but that is less than probable–nationwide anyways.
    Vancouver and Toronto are in their own world. :)
    Cheers,
    Rob

  14. Thanks Rob. You’re right, I must have used the wrong principal. Still, the point is the same with your numbers. Absolute comparisons starting at 5% vs 15% don’t make sense. You have to make relative (percentage) comparisons.
    Your point about using the new balance is relevant to buyers savvy enough to take a 5-year fixed mortgage, but many who are close to the edge will take a variable or a 35-year (diluting principal repayment). Also, people should strive for income gains, but not count on them. Its risky to count on a raise when we’re coming out of a recession.
    Still, I accept your points when talking about $220K. However, I happen to live in Vancouver, so your argument looks risky where many households will have 2-3x the mortgage and monthly payment increases closer to $500. You obviously agree. :-)

  15. Hi VM,
    Thanks for the feedback. Here are a few points that may be worth noting…
    * 70-80% of people have been getting fixed mortgages depending on which stats you look at.
    * Most people don’t live in Vancouver, and for most, a $200-$300 per month payment increase is manageable. (Not pleasant, but manageable…)
    * For people that do live in “high rent” locations, and don’t have the corresponding income, extra judgment is mandatory as we’ve noted.
    * Using the remaining balance is a valid comparison method regardless of the term chosen. If you need to refinance at the end of your term to lower your payments, your new mortgage is based on your remaining balance. Even with a variable-rate mortgage, you could refi mid-term if you had to, pay a 3-month penalty, and reset your payments based on the lower (remaining) principal amount.
    * With or without income gains (which historically tend to occur coming out of recession), the vast majority of people are liquid enough to make their mortgage payments if rates rose 3%. Where problems exist is for a minority of overleveraged individuals, and in cases where rates rise significantly more than 3%.
    This said, we continue to urge folks to qualify themselves using 3% higher rates (to reflect the potential cost of renewing). Moreover, I think it’s important that people putting down only 5% do not have expectations of moving for 5-10 years. (To allow for the possibility of falling home prices.)
    Take care,
    Rob

  16. Thanks Rob. I agree with all your points and I think you’re being responsible to keep people focused on qualifying using higher rates than currently posted.
    Looking back, I was thinking about your point here …

    Therefore, mortgage rates would have to go up significantly for mass numbers of people to get hurt at renewal.
    Anything is possible, but that is less than probable–nationwide anyways.
    Vancouver and Toronto are in their own world. :)

    If you consider that Metro Vancouver and Greater Toronto have greater than 25% of the Canadian population, wouldn’t you consider this to be mass number of people potentially at risk nationwide?

  17. Hi ValueMonkey,
    Thanks for the question. Here is one way to look at it…
    If you:
    1) Assume the Bank of Canada is right in suggesting that 5.9-10.7% of Canadians would be financially stressed by 3.00-4.25% higher rates (see this)
    2) Take out renters and those with significant equity from those numbers
    Then the remaining mortgage holders at risk of higher rates may be 4.0% to 7.3%. (See CIBC’s Analysis).
    Multiple that by 25% (Vancouver and Toronto’s share of the real estate market) and potential defaults in overheated markets are still small, even if you include a margin of error.
    Moreover, one might argue that most (or at least many) of these mortgagors at risk will not default.
    This is admittedly a rough estimation framework, but at least it’s based on reputable 3rd party metrics. So it’s not totally detached from reality….
    Happy New Year!
    Rob

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