Choosing the right mortgage: It pays to be informed!

Monday October 30th, 2017

Choosing the right mortgage: It pays to be informed!

Too many Quebec families are making the wrong financial choices... choices that can stay with them for the next 25 years.

Not enough people take the time to get all the facts or to talk to an expert about managing their liabilities.

There’s a lot of noise in the market. Will interest rates go up? Will Quebec housing prices drop in the next few years?

The Canadian economy is a bit precarious. The unemployment rate is low (good news), oil prices are low (not so good for the economy in Western Canada), inflation is around 2% (under control) and Canadian household debt is at an all-time high (very problematic). All of this suggests that interest rates will continue to be low for several years and that real estate prices in Canada will continue to rise.

We believe the next real estate crisis will be triggered not by rising interest rates but by a shortage of financing. Since 2012, the government has announced a number of measures to restrict access to credit. These measures are starting to slow real estate speculation, especially in Vancouver and Toronto. Foreign investors are now making their way to the Montreal area.

A number of steps have been taken to reduce systemic risk. For one thing, the government has put a cap on the mortgage amount insurable by the CMHC. Also, lenders can no longer get portfolio insurance for conventional loans or for homes worth more than $1 million. Canadian debt levels continue to climb at an unsustainable rate.

The Office of the Superintendent of Financial Institutions (OSFI) is now concerned about conventional loans and home equity lines of credit since most of these loans are held on the books of financial institutions.

 

No way out

With housing prices inversely correlated with interest rates, the price of real estate continues to climb. Simply put, the financial leverage of Canadian households is increasing because interest rates have reached a low of 3%. A rate increase could reverse that trend, and the shift has already begun.

Consider a young couple buying their first home. Let’s assume their gross annual family income is $90,000 and their car payments are $350/month.  The down payment will be a gift from their parents since they haven't saved up the 5% they need. How much do you think they can borrow to buy a home?

The answer is they could get a loan for $419,000, including the CMHC premium, to buy a $425,000 home. Is this reasonable?

Gone are the days when the rule of thumb for buying a home was three (3) times your gross annual income.

What will happen to the couple in 5 years? They’ll have no way out! Even assuming a 2% salary increase, if rates go up 1%, they’ll find themselves with a debt ratio that exceeds the defined standards and no option to leave their current financial institution or negotiate a better rate elsewhere. With the new refinancing rules now limited to 80% of the property's value, they won't be able to change financial institutions when the term is up, especially if the government wants to carry out stress tests using the posted rates of 4.94% for conventional loans. And keep in mind that the rate used for stress testing is gradually going to go up.

What happens if the market value of the couple’s home drops by 10% to 15% in the next 5 years? The mortgage balance will be higher than the value of their home. Once again they’ll be trapped, with no option to leave their current lender for better terms. Banks are currently trying to gain market share. Their posted 5-year rate is 4.84% but as of September 27, 2017, borrowers could negotiate a rate of around 3.19%. Since you can't leave your current bank if your ratio doesn't meet the standards, what’s stopping the bank from renewing the loan in 5 years at the posted rate rather than the rate you’ve negotiated?

 

Don’t be talked out of a variable rate

Over the last 5 years, a lot of borrowers have opted for a variable-rate mortgage. Historically, variable rates are about 50 basis points lower than a 5-year fixed rate. The advantage of a variable rate is its flexibility. For most variable products, the penalty in Canada for breaking the contract is limited to three (3) months of interest, unlike the outrageous penalties imposed by most lenders for fixed-rate mortgages. In the U.S., there is no penalty for fixed-rate mortgages. You can negotiate a 30-year fixed-rate mortgage and pay off your loan without penalty whenever you want.

Thanks to stress testing, clients who have a variable-rate mortgage have qualified for rates of around 5%. That means they have good borrowing capacity and a certain amount of leeway.

Unfortunately, lenders have started using scare tactics to sway consumers. They’ll call clients and tell them rates are going up so they should convert to a fixed rate right away. This is how they lead them into the trap. Lenders make a lot of money by charging huge penalties...probably more than they make in interest on the loan. Plus, once the loan is paid off, the capital is freed up for another loan.

When you convert from a variable-rate to a fixed-rate mortgage, you’re walking right into their trap. Getting good advice is key to making an informed decision between a fixed or variable rate. There are a number of things to consider: job stability, the possibility of moving, future renovations, debt ratios and spending priorities (education, health, leisure, etc.). And yes, there are some good fixed-rate products out there that charge a reasonable penalty to break the contract.

Lower isn’t necessarily better

Too many people think negotiating a mortgage is like buying a pair of shoes. Do you always look for the cheapest price you can find? You can buy a pair of shoes made in China for $10. But would you want to run a marathon in them?

Stop looking for the lowest rates and start looking at your needs. Look at other features like the penalty (ask your mortgage specialist to calculate it for you), and make sure you have a way out in case the unexpected happens (divorce, moving, major renovations or job loss, to name a few). Is your mortgage transferable/assumable? Do you have the flexibility to pay it off early? Is it a conventional or collateral mortgage? If no one ever talked to you about the features of your mortgage beyond the rate, you’re probably already caught in the trap.

Solutions and recommendations:

  1. Buy what you can afford, not what the banks say you can afford. Banks tend to be optimistic and very generous when granting loans. They’re also after your money. A Planiprêt broker can help you put together an after-tax budget to help you with your personal finances.
  2. Convert your home equity line of credit to a 5-year variable mortgage. With a prime rate of 3.20%, you can get a variable rate of between 2.35% and 2.50% (as of September 27, 2017). Even if the prime rate increases from 3.20% to 3.95% by 2020, the mortgage balance won’t be much different than with a fixed rate, and the penalty will be much more reasonable.
  3. Avoid converting your variable-rate mortgage to a fixed-rate mortgage. Often the conversion terms aren’t to your advantage. For instance, you may only get 1% off the posted rate. Financial institutions are hoping you’ll panic and fall into their trap by converting to a fixed-rate mortgage.
  4. If you’re worried about the prospect of rising mortgage rates, talk to a mortgage broker who can suggest some fixed-rate mortgages with more flexible contracts that you can get out of if your situation changes in the next 5 years.
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