Robert Brown
The Globe and Mail
The Globe and Mail
Could Canada could slip into the same traps that hurt the U.S. economy
in 2008-09? Some are sounding the alarm bells – at least on the housing
front.
Clearly, Ottawa is worried about the debt levels
being carried by the average household. Witness Finance Minister Jim
Flaherty’s recent announcement that he was changing the maximum
amortization on a government-backed mortgage to 25 years from 30 years.
The announcement was greeted with mixed reviews,
including loud criticism from those who worry younger generations will
have a significantly harder time being able to afford first homes. But
reducing the limit for mortgage amortization is not only good public
policy – cooling the speculative real-estate sector without killing the
home-construction industry – it is good for homeowners in general.
Here’s why.
U.S. banks and lending institutions took part in two
inappropriate activities in the U.S. housing and mortgage market prior
to 2008, both passively allowed by the government in the hope of
assisting low-income Americans to own their own homes.
First, banks were offering mortgages with low
introductory interest rates that would later (one to three years later)
rise to higher ultimate rates. Second, banks were offering mortgages at
very high ratios to the value of the house (even up to 100 per cent).
This was all fine – for both banks and home owners – so long as incomes
and house values rose.
It all came to a thunderous halt in 2008. As
homeowners’ mortgages with low introductory rates came up for renewal,
many could not afford the new higher payments that went along with the
higher ultimate rates. Americans had to walk away from their loans, and
therefore, from their homes – in droves.
At the same time, for those who had leveraged a very
high percentage of their home value in their mortgage, the falling house
prices meant that they now had a mortgage with an outstanding value
that was larger than the value of the house. So, they too, simply walked
away, handing the keys to their homes to the lending institutions.
This all snowballed into the exponential fall in
American home values in 2008-09, and the accompanying loss in value of
the mortgage assets held by the lending institutions – a very important
piece of the global financial crisis.
In Canada, we are fortunate that our successive
governments have always forced higher down payments for homes here than
those required in the U.S. With the new limits on the amortization
period, our government wants to dodge the American crisis. This is
prudent, and safeguards the economy in general. But the new limits are
also good for the individual home owner.
Let’s do some arithmetic. Consider a $100,000
mortgage. (Most mortgages are much larger, but you can get to the answer
to your personal situation easily by multiplying by the size of your
mortgage.) I will assume today’s five-year mortgage rate of 5.24 per
cent. If you take out a mortgage to be paid off over 30 years, your
monthly payment will be $548.10. Over 30 years, you will pay a total of
$197,316, including $97,316 in interest. If, however, you choose the
25-year mortgage, your monthly payment is $595.34 ($47.24 more a month).
Over 25 years, you will pay a total of $178,602 – $78,602 in interest,
just 80 per cent of the interest you would pay on the 30-year mortgage.
Further, you will own the house debt-free five years sooner. If interest
rates rise, the arithmetic becomes more dramatic.
Consider a $500,000 mortgage at 6 per cent. If you
choose the 30-year mortgage, you pay $2,974.12 a month for 30 years, a
total of $1,070,683, including $570,683 in interest. Using a 25-year
mortgage requires monthly payments of $3,199.03 ($224.91 more a month)
for a total payment of $959,709, including $459,709 in interest. In
other words, for an extra $7.39 a day, you can own your house five years
sooner and pay a whopping $110, 974 less in interest.
If a home buyer cannot afford an extra $7.39 a day in
mortgage payments, should they be in the market? Aren’t we all really
better off with the shorter amortization period?
The bottom line: The impact of this new legislation
is less pain than pragmatism. For once, we should be thankful to our big
brother in Ottawa.
Robert L. Brown was professor of actuarial
science at the University of Waterloo and a past president of the
Canadian Institute of Actuaries. He is currently an expert adviser with EvidenceNetwork.ca.
Regards,
J-P Dorion
Vice President of Sales, Mortgage Agent
J-P Dorion
Vice President of Sales, Mortgage Agent
