The world might be able to learn something from Canada about avoiding another housing-related financial meltdown, as the government recently announced several changes to the rules governing government insured residential mortgages. These changes are designed to reduce leverage in the system and promote housing market stability in Canada. (Find out how to get a tax benefit from your mortgage like your neighbors to the south, read Creating A Tax-Deductible Canadian Mortgage.)
The Canadian housing market and financial system have worked their way through the global recession and financial crisis in much better condition than the United States and many other countries. Average home prices in 2009 were higher than in 2006 in virtually every Canadian market.
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Despite this performance, the Canadian government has been concerned with the average level of household debt and has made several changes over the last few years. The latest changes were announced by Jim Flaherty, the Minister of Finance, on Jan 17, 2011, and these changes impact government insured mortgages and home equity lines of credit.
The first rule change impacts the amortization period on mortgages, which is the length of time that it takes to pay off the entire loan. The maximum amortization period is being reduced from 35 years to 30 years on mortgages where the loan to value ratio exceeds 80%. The loan to value ratio is a common metric used in the mortgage market and is calculated as the mortgage principal amount divided by the appraised value of the property.
A reduction in the maximum term will result in higher payments for Canadian homeowners, but a substantial reduction in total interest payments over the life of the mortgage. If a homeowner has a $300,000 mortgage at 6%, the five year reduction in amortization will require an $88 higher payment every month, but that homeowner will realize interest savings of $70,924 over the term of the mortgage.
Another change that the government is instituting is a reduction in the amount that a home owner can borrow against the value of their home during a refinancing. The new limit will be 85% of the value, down from 90% previously. A Canadian homeowner with a home appraised at $400,000, can now borrow up to $340,000 compared to the previous limit of $360,000. This $20,000 reduction means more equity in the home will be kept. (Refinancing your mortgage can be a quick way to save on payments, but it's not for everyone, read 6 Questions To Ask Before You Refinance.)
Home Equity Line of Credit
The final rule change is that the Canadian government will no longer insure home equity lines of credit which are non-amortizing. The concern here is that homeowners are rolling consumer debt into these instruments and therefore shifting the risk to the government. These are also riskier loans than first mortgages, with the majority of the lines structured as variable rate and non-amortizing or not requiring principal payments. Variable rates could mean increases in payment amounts thus increase the risk of overextending the individual's ability to pay.
The rules changes related to the maximum amortization and refinancing limits will go into effect on March 18, 2011, and the home equity line of credit change will be effective on April 18, 2011.
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These rule changes by the Canadian government are the third time since 2008 that the government has tinkered with the system in an effort to reduce leverage and risk in the Canadian housing market.
In October 2008, the government established a maximum amortization period of 35 years for mortgages insured by the government, and required a minimum down payment of 5% of the purchase price to new government backed insured mortgages. The government also made changes to the underwriting process on mortgages that made it more difficult to make loans to those applicants that weren't creditworthy. These changes affected minimum credit score requirements and loan documentation standards.
In April 2010, the Canadian government took on real estate speculators by requiring a minimum down payment of 20% on non owner occupied homes. The maximum amount that a homeowner could borrow in a refinancing was reduced to 90% from previous level of 95%.
The Bottom Line
The Canadian government has instituted several changes related to government insured mortgages in an effort to promote housing market stability. These changes will reduce leverage in the system and are part of an effort to increase home ownership in Canada. The United States and other nations that were hit hard by the financial crisis and housing bust should probably consider similar measures.
(This may be the biggest debt you'll ever incur. Learn why you should retire it sooner rather than later, check out Paying Off Your Mortgage.)