If it ain’t broke, don’t fix it, so the saying goes.
It’s something to keep in mind when considering suggestions that Bank of Canada Governor Stephen Poloz floated for the Canadian mortgage market in a speech earlier this week.
Among Poloz’s suggestions was that lenders and borrowers consider mortgages with durations of more than five years. While long-term mortgage options are currently available, only two per cent of fixed-rate mortgages issued last year were for more than five-year renewal terms.
Poloz believes longer-term mortgages would help improve financial stability, allowing borrowers to lock in interest rates and avoid frequent renewals.
But if fixed long-term mortgages are such a good thing for borrowers and the economy, why have homebuyers not opted for them in the past?
Most homebuyers, after all, do extensive due diligence on mortgage terms and conditions. Some options are obvious: borrowers would like to qualify for the lowest interest rate possible, and in uncertain times, they would like to lock in those terms for longer periods. When interest rates are expected to decline, borrowers usually prefer adjustable-rate mortgages to negotiate lower interest rates in the future.
There are several other considerations. For fixed-rate mortgages, lenders can impose penalties on borrowers who sell a property before the mortgage term expires. Also, lenders may restrict pre-payments that reduce the outstanding principal.
While lenders are usually focussed on imposing penalties or restrictions on prepayments, a 2012 paper in the journal Real Estate Economics noted that they should also recognize their benefits: namely that attractive prepayment options can attract “more creditworthy borrowers.”
By default, fixed-rate mortgages are more expensive. The longer the fixed-rate term, the higher the interest rate. Thus, if borrowers were to ask for longer renewal terms, lenders might charge even higher interest rates to account for the interest rate differential.
A borrower’s risk appetite matters as well. Risk-averse borrowers tend to prefer the stability and certainty of fixed-rate mortgages while the risk-loving would weigh the risk and reward of adjustable rates that could fall further (or rise) in the future.
The choice of a mortgage has broader impacts on labour market efficiency as well. A 2018 paper in the Journal of Money, Credit and Banking explains that fixed-rate mortgage borrowers impose a negative externality because such mortgages may “discourage borrowers from moving to other regions despite better employment opportunities.”
In Canada, the amortization period for a mortgage is usually 25 or 30 years, at which point the principal amount owed is reduced to zero. However, the maturity date of fixed-rate mortgages is often not greater than five years and most likely not greater than 10 years. At that point, the mortgage is fully due and payable. Thus, the mortgage must be refinanced for the outstanding balance at each maturity date.
This raises an interesting question. Why does the mismatch between the amortization period and mortgage term exist in the first place? Why aren’t lenders offering maturity terms that are the same as the amortization period?
For the answer, one must consult Section 10 of the Interest Act, which dates to 1880. The Act imposes certain restrictions on a lender’s ability to impose penalties on borrowers should they choose to prepay or redeem a mortgage after the expiration of five years.
In a 2018 paper by the C.D. Howe Institute, Michael K. Feldman explains that Section 10 was enacted to protect farmers from “being locked into long-term mortgages at high interest rates and subjected to large penalties when they sought to prepay.”
Feldman explains that exemptions were introduced to Section 10 later. However, the constraints still impede residential mortgages from having maturity dates that match their amortization periods. For this to happen, Feldman recommends an amendment to the Act that would afford a residential mortgage borrower “the right to redeem the mortgage at least every five years, regardless of the term of the mortgage, with a penalty capped at three months’ interest.”
Poloz also suggested that there may be an interest in developing a private market for mortgage-backed securities in Canada. However, Feldman says that the mismatch between the amortization period and maturity terms would expose security investors “to the risk that the mortgage might not be refinanced at maturity, leading to the need to liquidate the mortgage.” Thus, the mismatch between maturity and amortization acts as a structural constraint.
However an even bigger constraint is that the returns on prime residential mortgages are not attractive to large investors given other comparable investment opportunities.
There is clearly a need to innovate in real estate markets, including in mortgage finance. However, if the constraints highlighted in the C.D. Howe study are valid, innovation might have to wait for legislation.
Murtaza Haider is an associate professor at Ryerson University. Stephen Moranis is a real estate industry veteran. They can be reached at www.hmbulletin.com .
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