Borrowers will need to qualify for 5-year posted rate

From Canadian Mortgage Trends

For all variable-rate mortgages and fixed terms under five years, the new qualifying interest rate will be the greater of:

• the chartered bank 5-year posted rate (5.39% today), and
• the contract rate.

The posted qualifying rate will be published by the Bank of Canada each Monday at approximately 12:01am Eastern Time. Here’s the link: Posted Mortgage Rate (Look for series V121764.)

Previously when the Finance department tightened mortgage rules for CMHC loans, I thought they would be limited because of how low discount 5-year rates were. Now that it is the posted rate I think it will be successful limiting the amount of risk*** borrowers are capable of taking past April 19th. There is a concern of what impact this will have to the overall market but If the recent market strength was solely due to people stretching into 3% mortgages than a downturn was inevitable anyway.


***I misunderstood this rule - it actually only applies to those taking out terms under 5-year fixed. So the chance of rate shock occurring in 5 years to those stretching into the discount rate still exists. See previous post. At least this forces marginal buyers into 5-year terms.

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.