The 5-year Funnel

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.

  1. The small difference in the amount Mr Leveraged qualifies for exists today because of the spread between short and long term mortgage rates (variable vs 5yr fixed). If ever interest rates go up, or discounting on vrm’s steepens, that spread will widen considerably, and the difference in the qualifying amount will become much more significant.

  2. I’m not sure I understand what you are saying here.
    This is today:
    5yr Fixed: 3.80%
    5yr Posted: 5.39%
    5yr Variable: 1.95%
    What are you assuming will happen that would cause the fixed-variable spread to widen?
    5yr Fixed: ???
    5yr Posted: ???
    5yr Variable: ???
    If the spread widens, how would that make a difference in the qualifying amount?

  3. Rob,
    are you sure your source didn’t say “terms longer than five years will use contract rate to qualify”. Instead of terms “5 years and longer”. It just doesn’t make much sense and is quite obvious that it’s being done because that’s what the big banks want. If the finance dept was really interested in making sure the borrower had a buffer against rising rates, why would they throw it out the window just beacause you are taking out a five year term.

  4. A 680 credit score is very good, CMHC has/was insuring mortgages with buyers who’s credit score was below 580 which is very very poor, people with a 680 or above credit score probably understand money and how it works and are much more likely to avoid CMHC all together.
    I expect the recent changes to TDS, minimum credit score escalation, combined with the absence of very low speculator borrowing rates to have a very dramatic effect on the housing market.
    Expect 25 year amortizations and 10% down should follow.

  5. Are you sure about that? This is news to me. I was told that all mortgages must now qualify for posted rates or greater. Please clarify.
    Love your blog.

  6. There is a wrinkle in the new qualifying rate that bothers me. Chartered banks do not use their posted rates to conduct business. Instead, they vary their discount off of posted up or down as they please, and the posted rate floats well above the rates at which loans are actually being made.
    By using the chartered banks posted rate aren’t they being given the ability to regulate the market at no cost to their bottom line? If they had to actually lend at the qualifying rate, or even at that rate + a fixed amount, I think it would be a fairer market proxy. This way, it looks like a sub-group of lenders is being given discretion to regulate the overall lending market.

  7. There is no need to force people to qualify at posted rates on a 5 year fixed mortgage. The 5 year term, on its own, is enough of a buffer against rising rates.

  8. Can you provide a link where it notes that less than 5 years requires posted rates, but 5 years or greater requires contract rates?
    It looks to me like all terms require posted rates, do they not?

  9. Rob, I just don’t understand what you are saying with this article. If I am a high-ratio borrower, and I qualify at 5.39, why would I have to accept (or want to choose) a 5yr fixed rate over a variable at 1.95? All the govt is saying is: You can have whatever mortgage you like but you have to qualify at the worst possible rate. How does that funnel anyone into 5yr fixed?

  10. T-Ricky,
    I don’t want to speak for Rob but I think it is obvious.
    If you want a variable mortgage today you can qualify at a 3.50% rate [for example].
    After April 19 you will need to qualify using the posted 5yr rate. That rate is 5.39% right now.
    Naturally you are going to see more people take a 5yr mortgage instead of 1-4yr fixed or variable. For some it will be the only mortgage they qualify for.

  11. Interesting post. So, to summarize Rob’s points:
    – Anything under 5 years will be qualified at the posted rate. So, say I qualify for $500k @ 5.39%… I can borrow $500k for any term between 1-4 years, at any fixed or variable rate a lender is willing to give me.
    – Anything 5 years and over will be qualified at the discounted rate. Which means I’d qualify for a lot more than $500k if I take 5, 7, or 10 year fixed rate mortgage. (And that, T-Ricky, is why this will funnel everyone into a 5-year fixed mortgage… because people always want to borrow as much as they can.)
    If Rob is right, then this won’t make too much of a dent in prices. However, I’d still like to see another source confirm this information. I’ve read comments on other blogs from purported bank lenders who’ve stated that they’ll be using the 5-year posted rate for ANY mortgage product, no matter the term.

  12. Hi Aston,
    Thanks for the note.
    If individual lenders decide to impose stricter guidelines on 5-year qualification rates, it would be on their own volition. It is not a government/insurer requirement.
    If some choose to qualify 5-year fixed borrowers with a posted rate instead of the contract rate, it will put a dent in their market share because many competitors will be using the lower discounted rate.
    Cheers,
    Rob

  13. Question for Rob/operator:
    Say I’m with a big bank and I qualify for an insured mortgage under the 5 yr posted requirement 5.39%
    and choose a 1 yr term (contract rate = 2.5%).
    Now, I know my bank will let me renew 120 days before my maturity date. So let’s say its Oct/2010 8 months has passed will my bank allow me to now jump into the 5 year variable closed.
    Has there been any rules regarding renewals?
    Thanks,
    HB101

  14. If the mortgage is insured and the customer is changing terms then I would imagine that the lender must qualify the borrower at the prescribed qualifying rates on renewal.

  15. My understanding is that your assumption is wrong. Should be posted 5 year rate that BofC will set every Monday

  16. Rob,
    Your blog posting is spreading across the mortgage industry like wildfire. Some broker websites are now saying this is official gov’t policy.
    Do you have any link or official documentation from the government that you can share. If not any idea from your sources when a definitive release will be made? Seems like this has been imminent for weeks…

  17. Hi Roger/Bob,
    A number of readers sent us the new guidelines and we confirmed them from people in the industry.
    We’ve asked CMHC when to expect an official announcement on the qualifying rate and are awaiting that information now.
    Cheers,
    Rob
    The necessary disclaimer: All comments we make are ours based on the information we have. No such information is “guaranteed” for any purpose and is always subject to the government and/or insurers’ official announcements. No statements on CMT should be attributed to the government or insurers unless specifically quoted.

  18. Hi Bob — see above for a link to an article I wrote which sources the CMHC wording which is actually quite clear. I would post the link again here, but it would appear spammy if I started doing that, so scroll up to see it ;)

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