Why have subprime at all?

This troubleshooter video shows the dangers of subprime mortgages in Canada. A couple bought at the peak of the market in Wetaskawin with a 0 down 40 year mortgage from Wells Fargo. They are no longer operating in Canada and the uninsured mortgage was difficult to renew with other lenders.

One thing that caught my attention is that they were offered a mortgage for 10.75% by another lender at renewal. That's almost triple a discount 5 year rate! Is there any value in a loan like that? These loans exist for new borrowers as well, like this couple's original purchase, and they typically have these higher rates. One aspect of these loans is the longer amortizations which I covered in a previous post.

But it's not just longer amortizations. These predatory subprime lenders charge a significant premium on interest rates. With higher interest rates less money goes towards principal repayment, even with constant amortization. Consider the charts below which illustrates mortgage balance outstanding over time at various interest rates amortized over 25 years.


Looking at the first five years shows the pace of principal reduction over the initial term. With a 3.75% rate the $300,000 balance is reduced over $40,000 while at 10.75% it is reduced by less than $17,000. So not only are subprime borrowers paying an extreme amount in monthly payments, the higher rates makes it impossible to tackle the balance. With the buy to rent calculations so marginal even with low rates what is the benefit of homeowership under these conditions?

Answer: None. It's a trap.

The Case for Saving

For those with no down payment this post will present the case for saving and buying a home with more reasonable terms, as opposed to buying before Oct 15th when the new mortgage rules kick in.

I will compare the following options:

1. Buying a house for $300,000 now with 0% down and 40 year amortization

2. Buying a house for $300,000 next year with 5% down and 25 year amortization. The down payment will be saved into RRSPs and withdrawn using the first time home buyers program.

1. According to this table CMHC fees will be 3.1 + 0.6 = 3.7% of the loan amount. Total loan amount $300,000 + $11,100 = $311,100.

2. Rent instead and put $1250 per month (if possible) into GICs. After 1 year you will have saved $15,000 for a down payment. Also assuming a 26% top tax bracket you would get $3900 in tax savings (some of this refund in 2008 and some in 2009).

After 1 year track record of saving it is more likely you will be able to stomach the shorter amortization of 25 years. This combined with the down payment of 5% will reduce the CMHC fees to 2.75%. Total mortgage amount $300,000 - $15,000 + $7,388 = $292,838. Although the monthly payments will be higher the amount save in interest is substantial.

Down Payment Saved
Option 1: $0
Option 2: $15,000

CMHC fees
Option 1: $11,100
Option 2: $7,388

Mortgage Balance
Option 1: $311,100
Option 2: $292,838

Potential Tax Rebate
Option 1: $0
Option 2: $3900

Monthly Payment (assuming 5% rate from RBC calculator)
Option 1: $1490
Option 2: $1703

Total Interest Payments
Option 1: $403,887 (ouch!)
Option 2: $218,107

Year Mortgage Free
Option 1: 2048
Option 2: 2034

Bottom line is that option 2 is more than reasonable and you don't have to be a doom and gloomer or get a return on your savings! The same concept applies with any reduction in amortization and increase in down payment up to 20%.

Note: This comparison assumes flat home prices for 1 year and no return on RRSPs. Also see previous post comparing 25 and 40 year amortization.

Calgary July Stats

CREB released the July stats for Calgary. I have to commend the Calgary Real Estate Bubble Blog for calling Ed Jensen's sales pitch regarding 40-year mortgages:

“Buyers who wish to take advantage of the zero down mortgage program will need to hurry as this program, and the 40 year amortization program, are discontinuing shortly. Buyers can get more information about these programs from their REALTOR®.” concluded, Jensen.

Ed Jensen, August 1, 2008

I'm expecting Realtors (some who are struggling) across Canada to further increase their advertising/marketing budgets from now till October 15, 2008. With sales down 30%-40% yoy already, what will most of them do after that date?
I can already envision the new emergency marketing slogan:

"The best time to buy is now - before October 15, 2008."

CREBB July 9th, 2008


What did Ed Jensen say about these loans on July 12th?

The Canada Mortgage and Housing Corporation, the Crown corporation providing mortgage insurance on behalf of the government, eased the rules in 2006 to encourage homebuying.

That change, Jensen said, had little impact at the time.

"We didn't notice it in the market place," he said.

"So I believe in reverse, I don't think we're going to see a large impact on sales."

Funny that after these loans were introduced Calgary saw huge numbers in sales and prices and he didn't notice them. He seems to have noticed enough to make a sales pitch. See previous post.