Increasing the length of mortgage terms isn’t just about allowing consumers greater choice; it could have the added benefit of enhancing financial stability, writes Michael K. Feldman in the latest report from the C.D. Howe Institute, an independent not-for-profit research organization.
The idea of longer-term amortizations got a lot of attention in the lead-up to last fall’s federal election. PC Candidate Andrew Scheer was particularly vocal about his intent to raise amortizations for first-time homebuyers, along with various real estate boards. Lengthening mortgage terms would also have a big impact on consumers as well as the overall economy.
Feldman first waded into the conversation regarding longer-term mortgages in 2018. He has since been joined by Bank of Canada Governor Stephen Poloz, whose remarks to the Canadian Credit Union Association in 2019 noted three ways that more variety in mortgage durations would contribute to a safer financial system: if more borrowers had longer-term mortgages, they wouldn’t face the risk of having to renew at higher interest rates as often; homeowners would have the potential to build more equity within a single term, giving them more options upon renewal; and fewer borrowers would be renewing their mortgages in any given year.
Feldman adds that longer-term mortgages act as a protection in the event of systemic instability.
“A significant downturn in the real estate market could result in the insolvency of some mortgage lenders, particularly unregulated lenders. If this were to happen, borrowers from these lenders may not be able to renew their mortgages if their lenders were being liquidated and may not be able to refinance their mortgages due to the downturn in the real estate market,” Feldman writes. “This would lead to additional defaulted mortgages, which could further depress the real estate market. This risk decreases with more longer-term mortgages because there will be fewer renewals throughout the amortization term.”
There are, however, some regulatory obstacles that stand in the way of longer mortgage terms becoming commonplace in Canada, and one of those is demand.
The government would have to provide incentives to both borrowers and lenders to jump-start this demand, and/or make some regulatory changes. Feldman writes that these changes could include revising the stress-test for longer-term mortgages.
“Since the main purpose of the stress test is to predict the ability of borrowers to continue to service their mortgages if they must renew at maturity at a higher interest rate, it would be logical to loosen the stress test for borrowers willing to fix their rates for terms longer than five years. For example, if the stress test for a 10-year mortgage was set at the contract rate plus one percent (or zero percent) without any reference to a “Bank of Canada 10-year mortgage rate” (in recognition of the added refinancing flexibility after 10 years compared to five years), then borrowers could qualify for larger mortgages by opting for 10-year mortgages. This would encourage them to seek out longer-term mortgages and require lenders to offer competitive rates to retain market share.”
Other changes include amending the Interest Act to reduce the pricing premium that a lender would have to charge for its reinvestment risk on mortgages up to 10 years and reducing that risk in general by giving borrowers a short-term redemption period; increasing covered bond limits, and developing a private residential mortgage-backed securities market.
Limiting mortgages to five-year terms is thought to have grown out of a 19th-century statute that allowed the borrower to pay off the mortgage with a set penalty of no more than three months’ interest any time after five years following the initial date of the mortgage. The practice then evolved to where borrowers could renew their mortgage for another five years after the initial five-year period, with that renewal date becoming the new date of the mortgage. As long as the lender provided borrowers the opportunity to “redeem” the mortgage once every five years, they could prevent borrowers from prepaying the mortgage in full during the rest of the term without penalty.
As a result of this evolution, lenders can avoid reinvestment risks associated with prepayments by offering mortgages and renewals with terms no longer than five years, Feldman writes. From a borrower perspective, however, if there were increased desire for 10-year mortgages and increased competition from lenders to meet the demand, the cost of prepayment penalties would be reduced.
The majority of regulated financial institutions in Canada fund most of their uninsured residential mortgages by accepting deposits, including GICs that are insured by the CDIC. The CDIC, however, may only insure deposits having a term of five years or less. This limit posts a challenge for issuing longer-term mortgages from institutions that rely on these deposits.
This hurdle, however, may soon be removed. The federal government amended the CDIC Act to eliminate the five-year term limit on insured deposits, which comes into effect on April 3rd, 2020. This, Feldman believes, should make it easier for federally regulated financial institutions to fund longer-term mortgages—in theory.
“This will depend upon the retail demand for longer-term deposits,” he writes. “In a flat yield curve environment, as we have now, one would expect that most retail demand would be for shorter-term deposits; however, once the yield curve reverts to a more common rising curve, a demand for longer-term deposits may develop.”
Ultimately, Feldman writes, the current five-year term is “too well-entrenched to be overcome organically” and that the federal government will have to modify certain rules and create policies and programs in order to change the status quo.