Longer-term mortgages would benefit Canadian homebuyers by bringing more stability to the homebuying process, says a recent brief from the C.D. Howe Institute.
In “One More Case for Longer-term Mortgages: Financial Stability”, author Michael K. Feldman argues that mortgage periods of ten years or longer would decrease the number of renegotiations homebuyers would be required to engage in over the course of a decades-long amortization, thereby limiting their exposure to higher rates.
But the brief also notes that only two percent of all mortgages issued in Canada in 2018 were fixed-rate loans with a term longer than five years. According to C.D. Howe Institute associate director of research Jeremy Kronick, this lack of activity points to constraints on both the supply and demand side.
On the demand side, most Canadians simply don’t realize that longer-term mortgages are a possibility. “I think if you asked most people, they would think you can get a loan for five years or less, and that’s it,” Kronick says, adding that the institutions providing longer-term mortgages also charge premium rates to mitigate the losses in revenue they face from less frequent loan negotiations/interest rate hikes and early mortgage pay-offs.
A lack of consumer demand and a potential for decreased profits means most banks see little value in providing longer-term mortgages. If demand from homebuyers increased, however, Kronick envisions a scenario where lenders, forced into a more competitive market, begin expanding loan periods and lowering their rates.
“Right now, part of the issue is that the rates for the most part are quite high for anything longer than a five-year, so there’s just not much demand and there’s not much supply,” he says. “Hopefully you get to the point where the market’s competitive for something longer than a five-year, and by doing that you create a little more stability.”
Longer-term mortgages have repeatedly been endorsed by Bank of Canada Governor Stephen Poloz, but for such loans to become commonplace, two major changes must first occur.
Tweak Section 10
Canada’s loan terms are set out in Section 10(1) of the Interest Act, which says a mortgagor may pay off a mortgage at any time once five years have passed since the initial signing of the mortgage provided they pay a penalty equivalent to three-months’ interest.
Prior to the 1980s, banks began claiming that each time a loan renewal was signed, a new five-year loan was initiated, meaning early exits would still incur a charge of three-months’ interest. This distinction was challenged in court by borrowers who, asserting they were continuing the terms of the initial mortgage – now more than five years old – felt entitled to pay off their loans in the first year or two of the new term without penalty.
The court challenge failed. Section 10 has remained unchanged.
But simple tweaks could pave the way for more longer-term mortgages. The text could be amended to lengthen the redemption right from five to 10 years, but Feldman instead advocates for a change in language stipulating that residential mortgages could not be locked in for more than five years without providing borrowers a short period – 30 days once every five years for the duration of the loan, for example – where they could exercise a short-term redemption right.
“In theory, the cost to the lender of hedging a 30-day prepayment option should be materially less than hedging a multi-year prepayment option,” Feldman writes.
Revise the stress test
Feldman’s report suggests that the much-maligned revisions to the B20 lending guideline, known as the “stress test” that measures a borrower’s ability to pay back a loan at an interest rate two percent higher than she is attempting to qualify for, should be loosened for borrowers willing to fixt their rates for terms longer than five years.
If a borrower would be making the same payments for ten or fifteen years at a stretch, the risk of defaulting at a higher rate is greatly minimized, making a stringent and discouraging stress test less necessary.
“Anytime you lengthen the term, the stress test should be less binding,” Kronick says.
Changes such as these require government action. But one wonders how eager the federal government is to once again impose its will on the housing market.
“We’re talking about creating more stability,” Kronick says, “so maybe this is an issue they want to take up.”
One potential backfire scenario would see a wave of newly unbound homeowners flood the market, leading to the same feeding frenzies that forced the feds to step in and curb demand among buyers in the first place. That’s not an outcome Kronick expects to materialize.
“I guess it gets into the question of whether those who are currently excluded from the housing market would be able to take out a loan if they were offered a longer-term mortgage,” he says. “I’m not sure that there’s anyone new coming online by doing this because they’re still going to have to pay a premium for a longer-term mortgage. Whether they can afford that premium is unclear.”
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