Canada is tightening standards for mortgages over worries about rising home prices, with the Greater Toronto Area, Hamilton and Montréal markets particular causes for concern.
As is the case in many U.S. housing markets, desire for more space during the pandemic and low interest rates have boosted sales of single-family homes. But there’s a shortage of listings and builders can’t keep up with demand.
Mortgages work a little differently in Canada than in the U.S., however. Most mortgages have a term of five years or less. Although monthly payments are based on a 25-year amortization schedule, borrowers will typically need to renew their mortgage several times before they own their house. Mortgages with longer terms are available, but they often carry steep fees if you sell your home and pay off your mortgage early.
Since it’s harder to lock in a low rate for longer than five years, Canadian borrowers can be vulnerable to rising interest rates. One way to protect borrowers from getting in trouble is to make sure they would still be able to afford their monthly payments if their interest rate goes up when they have to renew their mortgage.
This week, Canadian officials announced that starting June 1, borrowers taking out new mortgages will have to be able to demonstrate that they’d still be able to make their monthly payments if their interest rate was suddenly increased by 2 percentage points, or to 5.25 percent — whichever is greater.
With rates on 5-year mortgages currently averaging 4.79 percent, that means many borrowers will have to show they have enough income to comfortably repay a loan with an interest rate of 6.79 percent.
Source: Bank of Canada.
“The recent and rapid rise in housing prices is squeezing middle class Canadians across the entire country and raises concerns about the stability of the overall market,” Canadian Minister of Finance Chrystia Freeland said in announcing the change for government-insured mortgages. The Office of the Superintendent of Financial Institutions said it will adopt the same standards for uninsured mortgages on June 1.
“At an individual level, Canadians need to be prudent in taking on new debt. It is important to understand that the recent rapid increases in home prices are not normal,” Bank of Canada Governor Tiff Macklem said at a press conference. “Even without a shock, some of the factors that caused prices to rise fast could reverse later, and that could leave some households with less equity in their homes. And interest rates are unusually low. Borrowers and lenders both have roles in ensuring that households can still afford to service their debt at higher rates. Counting on ever higher house prices to build home equity that can be used to refinance mortgages in the future is a bad idea.”
A Nanos Research Group poll for Bloomberg News found that nearly nearly half of Canadians would support the Bank of Canada raising borrowing costs to cool demand for houses and stabilize prices. But the tightened underwriting standards aren’t expected to have much of an impact on home prices, Benjamin Tal, deputy chief economist at Canadian Imperial Bank of Commerce, told Bloomberg.
Household debt and housing market imbalances seen as risks
The move to tighten mortgage underwriting came on the same day that the Bank of Canada published an annual assessment of risks to the country’s financial system. The report identified six “key vulnerabilities” including elevated household debt, imbalances in the housing market, and fragile corporate debt.
“With so many Canadians working and studying at home, people want more space. Consumer preference, combined with low interest rates that make borrowing more affordable, has boosted demand for single-family homes, particularly in suburbs and outlying areas of major Canadian cities,” Macklem said in releasing the report. “Housing supply has not been able to keep up with this surge in demand, and this has pushed prices for single-family homes sharply higher in several markets.”
In their review, Bank of Canada economists noted that sales of existing homes were near a record high in April, with prices up 23 percent from a year ago. Although much of the increase in home prices was due to fundamentals like supply and demand, there are worries that it may also have been driven partly by expectations of future price increases.
“When house price growth is elevated, some households may be tempted to buy now for fear of higher prices in the future,” the report said. “In such a scenario, housing purchases are made sooner than they normally would, raising demand and prices, particularly when supply cannot keep pace.”
Some markets are showing signs of “extrapolative expectations,” the report said — people are expecting prices will rise in the future, “simply because they have risen in the past, without regard to what fundamentals suggest.”
The Greater Toronto Area, Hamilton and Montréal are experiencing extrapolative house price expectations, and Ottawa is nearing this threshold, the report said.
Macklem said the increased prevalence of mortgages made to borrowers with high debt-to-income ratios is “of most concern.”
Source: Bank of Canada.
In some cities, “house price exuberance” seems to be driven mainly by people buying a home to live in rather than by investor demand or house-flippers.
“Nevertheless, the share of properties purchased by investors—individuals who obtain a mortgage to purchase a property while maintaining a mortgage on another property—has been rising in recent months,” the report said.
Source: Bank of Canada
Freeland noted that on On Jan. 1, 2022, Canada will institute a national tax on vacant property owned by non-resident, non-Canadians.
“Houses should not be passive investment vehicles for offshore money,” she said. “They should be homes for Canadian families.”
Since 2015, Freeland said, Canada has made “historic investments” to increase supply, including:
- A $70 billion National Housing Strategy, launched in 2017, to support the construction of up to 125,000 affordable homes
- A First-Time Home Buyer Incentive which reduces first-time buyer’s mortgage payments to make buying a home more affordable
- A $300 million investment to support the conversion of the empty office space into affordable housing
- A $14.9 billion in public transit projects over the next eight years, to provide working families with more options of where to buy a home