In Canada’s mortgage system, the needs of homeowners often clash with the needs of the banks. There’s a better way
In Canada’s mortgage system, the needs of homeowners often clash with the needs of the banks. There’s a better wayseries. In a time of geopolitical instability and a shifting world order, the challenges facing Canada's economy have only gotten more visible, numerous and intense.
This series brings solutions. What would you do if your mortgage came up for renewal and you couldn’t afford to keep your home? A lot of Canadian homeowners have had to face that question. The Bank of Canada went on an aggressive interest-rate hiking cycle in 2022. Prime rates, bond yields and mortgage rates followed. Most homeowners were on fixed-rate mortgages and not immediately affected, but they faced the prospect of much higher rates at renewal. Consider a homeowner who’d bought in 2018 with a five-year fixed-rate mortgage. By the time of renewal in 2023, five-year rates were as much as four percentage points higher. The homeowner’s mortgage payments would have risen by nearly 50 per cent. That could be close to $2,000 per month for a million-dollar mortgage. If the homeowner was unable to afford the increase, they would have been forced to sell. Fortunately, those high rates lasted only a year before they started coming down, and so homeowners who had mortgages coming up for renewal dodged the peak. But all still faced higher rates – manageable, but painful. In hardest-hit Toronto, delinquency rates – the proportion of mortgage holders who are behind in payments by 90 days –Canadian homeowners have now had a taste of renewal risk – the risk that rising interest rates will cause mortgage payments to grow on renewal – but they are still unable to protect themselves from it. Available mortgages remain the same, so home ownership continues to be both more risky and less affordable than it needs to be. Can this be fixed? First, we need to acknowledge the fundamental needs of mortgage borrowers. For most borrowers, their home is their largest asset, and it is a very long-term asset indeed. The land will be there forever and the house might be good for a hundred years. The best way to borrow for such a long-term asset is with a long-term mortgage, what I call a “Matching Mortgage,” for which the interest rates and monthly payments are fixed until the mortgage is repaid. Imagine a 25-year Macthing Mortgage. Homeowners would completely avoid renewal risk. But these needs of homeowners clash with the needs of the banks, the dominant providers of mortgage loans. Their money to finance mortgages comes mostly from short-term deposits, such as chequing accounts and savings accounts. The safest way for them to lend is with floating-rate or shorter-term fixed-rate mortgages that typically run for terms of one, three or five years. With long-term fixed-rate mortgages, banks would face the opposite renewal risk - the risk that monthly mortgage payments didn’t rise even when their cost of deposits did. Banks cannot face this renewal risk, so banks cannot provide Matching Mortgages. If we want a better mortgage system, we must look elsewhere. We can start by looking to the $6-trillion Canadian bond market. Banks are active players in the bond market but only for shorter-term bonds, such as those seen for the standard five-year fixed mortgage.In Toronto, delinquency rates – the proportion of mortgage holders who are behind in payments by 90 days – have more than quadrupled since the low.The natural lenders for Matching Mortgages would be life insurance companies and pension funds, who have a longer horizon. We call them long-term lenders because they have long-term liabilities that are best matched by long-term loans. Matching Mortgages could be a perfect fit between Canadian homeowners and insurers and pension funds. Not only are they incentivized to provide such long-term loans, their long horizon allows them to bring special capabilities too. Imagine a life insurance company offering a “whole life mortgage,” under which they would allow homeowners to move their mortgages from one home to the next, add and blend new borrowing if required, and even transition to an interest-only or reverse mortgage basis as they approached retirement. Imagine a pension fund offering an inflation-indexed mortgage under which the initial monthly payments would be set 20 per cent lower in exchange for an agreement that payments would be adjusted each year in line with inflation. If we can welcome a new class of lenders to Canadian residential mortgages, the innovation and benefits may be endless. So why don’t insurers and pension funds offer Matching Mortgages already? Their problem has been an ancient piece of Canadian legislation called the Interest Act. After the first five years of a mortgage, it prohibits lenders from seeking compensation for losses they might incur if borrowers repay their loans early. Without this protection beyond five years, lenders will not lend for more than five years. While purportedly protecting homeowners from unfair charges, the Interest Act actually denies them the ability to protect themselves against renewal risk and protects banks from competition. Homeowners’ inability to protect themselves from renewal risk by choosing Matching Mortgages leads to a number of unintended consequences. Risks can behave like dominoes. Homeowners’ renewal risk becomes lenders’ credit risk because lenders need to protect themselves against borrowers being unable to carry their mortgages on renewal. And lenders’ credit risk can then become a risk to Canada’s banks because of the massive size of their residential mortgage holdings. If lenders’ inability to renew leads to a large number of foreclosures, we will also have to fear a vicious circle with the economy declining. With all these dominoes at play, regulators of financial institutions take notice, and with that comes another problem. Regulators require lenders to protect themselves in at least two ways: first, ensuring that homeowners’ earnings would be sufficient to support the mortgage payments even if interest rates were two percentage points higher; and second, limiting the amortization period, perhaps to 30 years. That’s because rising mortgage rates can lead to significant growth in required monthly payments, and longer amortization periods will make these increases even larger. But in protecting themselves against potential borrower distress, short-term lenders reduce potential homeowners’ borrowing capacity by about 25 per cent. This significantly reduces the affordability of home ownership and may also exacerbate the wealth gap between younger and older Canadians.Home ownership continues to be both more unpredictable and less affordable than it needs to be, as Canadian homeowners face the risk that rising interest rates will cause mortgage payments to grow on renewal.Many homeowners think they are adequately served by the current system, but they face limited choice, higher monthly payments and unavoidable exposure to renewal risk. If interest rates ever returned to the levels reached in the early 1980s, the result would be calamitous. We can and should offer homeowners the option to protect themselves against renewal risk. Matching Mortgages today would have slightly higher interest rates than five-year mortgages, in just the same way that 10-year bonds have a higher yield than five-year bonds. This could be offset by extending the amortization period by about five years, after which the monthly payments would be about the same. Once borrowers are protected against renewal risk, we can safely adjust the mortgage underwriting process to permit lower monthly payments and greater housing affordability. Innovation to Canada’s mortgage market is long overdue. While renewal risk to borrowers was largely forgotten during 40 years of declining interest rates, interest rate increases over the past few years have brought it back into focus. Matching Mortgages may not be the best solution for all borrowers. Nevertheless, with the addition of new lenders, new competition and new mortgage alternatives, they will bring an improvement for all.Bank of Canada expected to hold rates amid oil-driven inflation riskHe’s useful in a crisis – but is he any good at politics? A look at Mark Carney’s first year
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