3.89% is not enough

There is still some uncertainty regarding the changes in qualifying for CMHC insured mortgages. Specifically which rate to use for qualify for a 5-year fixed term? Is it the posted rate or the discount? The difference between these rates is significant, with a few lenders appear offering 5-year fixed at 3.89% while bank's posted is 5.39%.

Some lenders see this uncertainty in policy troubling with a couple of examples at Canadian Mortgage Trends Blog.

We talked to some high level folks at the insurers and not even they know what interest rate will be used to qualify borrowes come April 19.It could be the 5-year posted rate or the 5-year discount rate. One source told us it might even be an offset from prime (like prime + 2%).
...
We hate to say it, but these rules seem to have been rushed out with insufficient industry consultation.

And comment on a related post

Its pretty irresponsible of the govt to withhold the most important bit of information for this long.

Maybe the furious lobbying efforts of various interest groups over this rule change are still going on behind the scenes?

How hard is it for them to just verify what most people assume will be the case?

If they use "posted" rates then no one will borrow from a big lender ever again until they change their posted rates to equal their discounted rates.

I bet the new rules are substantially different from what's been announced by the time April 19th roles around.

How smoothly this new policy is rolled out is trivial. Instead consider those who qualify assuming the discount 5-year fixed rate of 3.89%. This is the type of borrower in question here.

Qualifying rate: 3.89%
Amortization: 35 years
Maximum Total Debt Service Ratio: 44%
Maximum Gross Debt Service Ratio: 35% (I am using this ratio to give lenders the benefit of the doubt, according to CMHC loan product sheet someone with a credit score over 680 only needs to worry about TDS ratio. See previous post)

Gross Income $100,000

A 35% GDS ratio allows for $2,917 in housing payments including taxes heating and mortgage.

More Assumptions:
Taxes: $280
Heating: $120
=
$2,517 left for monthly mortgage payments.

Maximum mortgage of $580,000, or 5.8x income.

That is with the new rules assuming the discount rate! With a maximum 44% TDS ratio this borrower could potentially be paying an 9% of gross income towards other debts BEFORE taking out this mortgage. That is $750/month!

What are the risks of this? Simply consider the potential of a return to status quo of 2% inflation, slow income growth of 2%/year and a moderate rise in the fixed rate to 7% in 5 years.

In 5 years the mortgage balance is reduced to $536,788, or by 7.5%. At this point it will need to be renewed at a potentially higher rate with 30 year remaining in amortization.

Monthly Mortgage costs renewed @ 7%: $3535
Heating: $132
Taxes: $309
Total Housing Costs: $3976

Monthly Income: $110,408 / 12 = $9201

Gross Debt Service Ratio: 43.2%

Take the possibility the borrower doesn't do much about their other debt situation over 5 years. At renewal 50% of the $750/month debt servicing was interest costs and this is increased by 50% (say from 6% to 9%). In this case other debt payments will increase to $938.

Total Monthly Housing and Debt Costs in 2015: $3976 + $938 = $4914
Total Debt Service Ratio: 53.4%

That's before tax income and even in this fairly mild scenario causes extreme stress to the borrower. I hope this makes the case that qualifying for discount 5-year rates is still too risky to be insured by the CMHC.

...I have to add the obligatory... GO! CANADA! GO!.. hockey game starts in 5 minutes.

What is the required debt service ratio?

Debt service ratio is an important qualifying metric for mortgages indicating what percentage of income goes towards housing and other debt payments. It remains a mystery to me what this number is in Canada. On one part of their website CMHC states that gross debt service ratio, which represents mortgage payments, heating, taxes and a portion of condo fees should not exceed 32% of income. It also states that total debt service ratio, which includes all other debt servicing such as visa bills and vehicle payments should not exceed 40% of income.

This is a way of estimating the maximum home-related expenses you can afford to pay each month. To qualify for CMHC insurance, the total should not exceed 32% of your gross monthly household income.

This enables you to estimate the maximum debt load you can carry each month. It should not exceed 40% of your gross monthly household income.

The choice of words of should not as opposed to must not is interesting. Following the link I noticed there is a table estimating how much one can afford with different incomes and down payments. It assumes an interest rate of 8% and a GDS ratio of 32% which seem to be the stuff of ancient history...



The details of the loan products on the CMHC website show a maximum total debt service ratio of 44% with the gross ratio not considered. This product sheet was updated March 27, 2009. Note the use of words such as "guidelines" and "recommended" as opposed to "rules" and "limits".



Looking back at this article when 40-year mortgages were scrapped there is a quote regarding debt service ratio rules.

Effective Oct. 15, the maximum mortgage amortization period for new mortgages will be reduced from 40 years to 35 years. All mortgages must have at least a five per cent down payment. Homebuyers must have a minimum credit score of 620 and a maximum of 45 per cent total debt service ratio (the amount of gross income that is spent on servicing debt and housing-related expenses such as heat or condo fees).

They were using more before this?!

Some online mortgage calculators appear to use 32%, but there is anecdotal evidence that higher ratios are being used. This is troubling because the combination of historically low interest rates (including 5-year fixed rates under 4%), longer amortization and high debt service ratios will certainly lead to increased foreclosures going forward.

In addition to the recent mortgage rule changes CMHC should clearly and consistently identify a maximum gross debt service ratio and this should not exceed 32%.

New Rules

Flaherty has announced new mortgage rules to take effect by April 19th to "help negative trends from developing". From the Deparement of Finance website:

• Require that all borrowers meet the standards for a five-year fixed rate mortgage even if they choose a mortgage with a lower interest rate and shorter term. This initiative will help Canadians prepare for higher interest rates in the future.
• Lower the maximum amount Canadians can withdraw in refinancing their mortgages to 90 per cent from 95 per cent of the value of their homes. This will help ensure home ownership is a more effective way to save.
• Require a minimum down payment of 20 per cent for government-backed mortgage insurance on non-owner-occupied properties purchased for speculation.

5-year fixed mortgages are still under 4% so the preparation for future rate increases is minor. I hope this doesn't give the any buyers a false sense that qualifying for the 5-year fixed makes their mortgage safe from potential rate hikes - I think using the 3x income rule as a more reasonable measure.

Absent was a decrease in amortization and increase in down payment. I have previous posts discussing why shorter amortizations and larger downpayments are important. The previous two posts were regarding 0 down/40 year mortgages but the same principles applies to 5/35 mortgages as well. CMHC fees are reduced for each additional 5% down (up to 20%) and total interest costs are reduced as amortization is shortened.

CMHC minimum changes

There has been a lot of talk about CMHC rule changes to prevent a bubble. The rules should be modified to prevent people from getting in over their heads, regardless of where prices are. It appears that 30 year/10% down is not in the cards, but that does not mean that there aren't some other ways of preventing foreclosures.

1. Ensure the minimum downpayment is from personal savings, not another loan.
2. Raise the credit score required for higher amortization mortgages.
3. Ensure those qualifying on historically low variable rates are able to handle higher payments. I suggested 6% here. For those that don't qualify for 6% then at least limit the term to a 5-year fixed. The choice to go variable should not be done for affordability.
4. Verify incomes with tax statements if self employed individuals want CMHC insurance for high ratio mortgages.

I think the entire discussion being framed around preventing a bubble was a mistake. The goal of the changed rules should not be to cool down the housing market, but to prevent future foreclosures.

Edmonton Sales Down

The REALTORS Association of Edmonton and the Edmonton Real Estate Blog have posted January statistics. Just like in Calgary seasonally adjusted sales are very weak. In fact, while we would normally expect sales to increase 18% in January they fell by 7%.

Despite slower sales new listings are following the same rate as the 2nd half of 2009 seasonally adjusted.


The seasonally adjusted sales/new listing ratio has decreased to 51% (non-adjusted is 40%). A sales to new listing ratio of 50% indicates a market with no price appreciation.


The weaker market is due to sales not increasing with listings last month.

Below are the charts for sales and listings seasonally adjusted.

Calgary January statistics - Weaker sales

Calgary stats for January have been posted by Bob Truman and it is clear they have deteriorated on a seasonally adjusted basis. Normally we could expect a 27% increase from December to January, but instead sales were flat. They have moved closer to a rate equivalent to the six months of the financial crisis labeled scorched earth on the chart below. An explanation of all the benchmarks can be found in this post.

Seasonally adjusted new listings are occurring at a rate very close to the last half of 2009.


The seasonally adjusted sales to new listings ratio currently sits at 51% (non-adjusted is 40%). A 50% ratio leads to a market with stable prices.

The deterioration in the ratio is a result of sales not increasing as they normally do in January.

Seasonally adjusted sales have fallen for 3 consecutive months.


Listings are closely following the same pattern as previous years.


Übernerd alert: All the benchmarks and seasonally adjustment factors were calculated last month and I did not re-calculate them using new data from January.