Canada’s new mortgage rules protect lenders or home buyers?

Any builder will tell you a house is only as good as its foundation. The same rule applies to a national housing market.

On July 9 a new set of mortgage rules will go into effect aimed at firming up the financial foundations of the Canadian housing market.

Among the changes is the rolling back of the maximum government insurable amortization period to 25 years from thirty years. That means banks can no longer entice cash-poor wannabe homebuyers with lower regular payments by stretching them out over thirty years. The regular payments may be bigger but in the end the total amount of interest paid by the borrower is less.

In addition, the maximum allowable amount that can be borrowed against the appraised equity in a home will be lowered to eighty per cent from 85 per cent. The change is expected to decrease the risk of higher borrowing rates and falling house prices making the total amount owing greater than the value of the property.

Canada Finance Minister Jim Flaherty admits the move could close the door on nearly five per cent of new home buyers. That may be an understatement considering forty per cent of new mortgages last year were for amortization periods between 25 and thirty years according to the Canadian Association of Accredited Mortgage Professionals.

It's the fourth time the Federal government has tightened the mortgage rules since the U.S. real estate meltdown five years ago, when highly leveraged purchases met crumbling house prices. Even now the amount owing on one in four U.S. homes is higher than the appraised property value.

New rules protect lenders or home buyers?

Ottawa is also serving notice to lending institutions to ensure borrowers meet basic requirements and have appropriate insurance if they don't repay their loans.

It's all a bit of the old closing the barn door after the horse is gone - with a twist. The latest clampdown is from the same Conservative government that opened the door in the first place by caving to the finance industry and loosening lending requirements in the early 2000s. One of those loosening measures that survived is the five per cent minimum down payment. Technically you can still buy a house on your credit card.

While the initiative may seem like protection for prospective homeowners it's more about making sure the big banks get their money back. Keep in mind mortgage insurance through the government owned Canada Mortgage and Housing Corporation insures the lender. Home buyers with less than a 20 per cent down payment must pay the premium.

When the new rules were announced in late June the government was quick to trot out the average 152 per cent debt-to-income ratio. Debt-to-income measures the total amount of household debt against the annual average Canadian household after-tax income. In the 1990s the debt to income ratio was 90 per cent.

Shocking as it may seem, the debt-to-income ratio says little about the financial state of an individual household and does not distinguish between low interest, equity building, mortgage debt and high interest consumer debt. A young household with a $60,000 income and a $200,000 mortgage, for example, would have a debt to income ratio of 330 per cent. A household with a $60,000 income and credit card debt of $30,000, on the other hand, would have a seemingly more manageable debt to income ratio of 50.

To address the ballooning debt to income ratio Ottawa is also tightening the rules surrounding debt serviceability — the ability of households to manage their debt on a monthly basis. The banks measure debt serviceability in two ways:

  1. The Gross Debt Service Ratio (GDSR): Monthly housing costs (normally mortgage principle and interest payments), property taxes, secondary financing, heating and fifty per cent of condo fees, if applicable. Ottawa would like to cap the GDSR at 39 per cent of a household's monthly income.
  2. Total Debt Service Ratio (TDSR): Housing costs (same as GDSR) plus payments on lines of credit, credit cards and other debt. Ottawa is calling for a maximum TDSR of 44 per cent.

Thanks to lax lending rules the portion of household income devoted to debt each month has also skyrocketed, putting thousands of Canadian households on a financial treadmill while widening the profit stream for the banks.

But even the way the government measures debt serviceability is skewed toward the lender. Both methods calculate before-tax income because the lender, who has the property as collateral, is often in line for payment ahead of the Canada Revenue Agency if the borrower defaults. Wise borrowers who want to stay on the CRA's good side may want to calculate their own debt serviceability by factoring after-tax income instead.

Also, with home ownership becoming more and more elusive, prudent Canadian households are opting to make sacrifices to pay down debt more aggressively. Tighter debt serviceability requirements take away that option, making it tougher for young families to break ground on their own financial foundations.