The Mortgage Renewal Trap

Wanderer
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source: https://selectinsuregroup.com/mortgage-insurance/

The year was 2007. Steve Jobs unveiled a funny-looking little product named the iPhone and changed the world of smartphones forever. The final Harry Potter book, Deathly Hallows, was released to rave reviews. And whispers of something bad called a “sub-prime mortgage” was starting to grow into something that could no longer be ignored.

Little did we know the freight train that was about to hit us.

There were a lot of causes of the Great Financial Crisis, but the main one was banks handing out mortgages to people who had no business owning property. No income, no jobs, and no assets, or NINJA loans, were commonplace, and the loans extended to these borrowers were sketchy adjustable rate mortgages, or ARMs, which were structured to offer low “teaser” rates to borrowers at first before leaping higher.

The banks (or more accurately, less scrupulous secondary lenders) allowed this because their strategy was:

  1. Give idiots mortgages you know they can’t pay
  2. Wait a few years until the payments jump higher and they default
  3. Foreclose on the house to recoup their investment while pocketing their payments
  4. Profit!
  5. Repeat!

Obviously, this plan fell apart because too many borrowers defaulted at once, which started a chain reaction that nearly destroyed the economy.

Back then, there was a lot of smug chuckling on this side of the border. Canadians, we thought, would never do something this stupid. Our governments and banks were too smart to loan out money to people with no jobs, so this kind of situation could never occur here.

The smugness wasn’t completely unwarranted. Canada didn’t experience anything close to the wave of foreclosures that the Americans did, and none of our banks fell over, or even came close. For a while, the Canadian dollar even hit parity with the USD, which was an interesting experience.

But now, Canada is facing our own housing crisis moment. The root causes are different this time, of course. Instead of lax lending from sub-prime mortgages, we have a rapid rise in interest rates, coupled with an extremely indebted population and one of the most overpriced real estate markets in the G20.

Will we come out of this with our smugness intact? Or will it be the Americans’ turn to look northward, clucking their tongues and shaking their heads at how badly we’ve managed to fuck things up over here?

Nobody knows, but here’s our country’s plan on how to defuse this housing bomb. You tell us whether you think it will work.

Canada’s Plan

The world learned an important lesson in 2008, which is Lots of Houses Defaulting At the Same Time = VERY VERY BAD.

Defaults themselves may be unavoidable (like when someone loses their job and can’t afford the mortgage), but if we can get it to be spread out over a longer period of time rather than all at once like a giant wave, that would make this a manageable problem rather than a full-blown economic crisis.

Back in 2007, the source of that wave was Adjustable Rate Mortgages, or ARMs. In the US, ARMs are relatively rare, precisely because people have clued into the fact that these things are kind of dangerous. In 2022, according to CNBC, ARMs accounted for just 13% of loan applications. The vast majority of US borrowers opt for fixed rate mortgages, even if the interest rate is higher.

That’s because in the US, a fixed rate mortgage is…well, fixed. The interest rate and the monthly payments stay the same regardless of what the Federal Reserve does, and it stays the same throughout its entire lifetime.

In Canada, the two most common types of mortgages are Fixed Rate Mortgages and Variable Rate Mortgages, which you’d guess would be the equivalent of the American Fixed Rate Mortgages and ARMs, right? Not quite.

For one thing, Canadian fixed rate mortgages are only fixed for a specific term, typically 5 years. After that point, we have to renew them, either at our existing bank or by porting them over to a new lender. When that happens, they get renewed at whatever the prevailing interest rates are. So our fixed rate mortgages aren’t really fixed.

Our VRMs aren’t quite like ARMs either. VRMs are sold with an interest rate that’s written as a spread from the bank’s posted prime rate. So if you get a VRM at Prime + 2%, and the bank’s Prime rate is 4%, then your interest rate is 6%. But if the prime rate changes, your VRM adjusts immediately.

This is different from how ARMs operate. ARMs typically have a period of time where the interest rate is fixed, then it starts adjusting. If you’ve ever read articles talking about 10/1 ARMs and wondered what the Hell that means, the first number is how long the rate remains fixed, and the second number is how often the rate resets going forward. So a 10/1 ARM would have a fixed interest rate for the first 10 years, then reset every 1 year afterwards.

So if we were to describe Canada’s mortgages using the language American sites use, our “fixed rate” mortgages are really 5/5 ARMs, with an initial “teaser” interest rate that lasts 5 years, then it resets every 5 years afterwards. And our VRMs would be something like a 0/1 day ARM, meaning no fixed period, with the interest rate resetting, essentially, every day based on what the bank’s prime rate does.

Remember, payments rising to unaffordable levels on ARMs is what triggered the US housing crash, and ARMs only represent 13% of the market. But here, every mortgage is an ARM. So the conditions for a housing crash are very much in play.

The one saving grace is that the majority of the mortgage market is not VRMs, but rather “fixed rate” mortgages (or rather, 5/5 ARMs). This means, that most mortgage holders haven’t seen their payments jump yet, but it’s coming when they renew.

What Happens At Renewal

Short answer: The bank’s going to ask for more money. Potentially, a lot more.

When that happens, the mortgage holder has only a few options.

Option #1: Suck it Up

This is what the bank desperately wants the homeowner to do. The banks win because they get more money going forward, the homeowner grumbles but pays up, and nothing bad happens.

Option #2: Find Another Lender

If the homeowner doesn’t like the offer their bank is giving them, they can shop around for another lender. Shopping around is generally a good idea at this time anyway, but higher interest rates affect all lenders, so I doubt this will make a huge difference.

Option #3: Lengthen the Amortization

Extending your amortization means that you lengthen the amount of time it takes to pay off the loan. This results in lower, more affordable payments since your payment period is now stretched out over a longer period of time, but it’s not a magic bullet.

For one, you’re going to be paying more interest overall. A $500,000 mortgage with a 25 year amortization at today’s rate of 6% would result in a monthly bill of $3,211.51. It would also cost $466,452.10 in interest over the course of the loan. If you were to extend that mortgage over 30 years, the monthly cost would drop to $2,997.75, but the total interest you’ll pay rises to $579,190.95, a difference of over $100k. So this option might help, but it’ll cost you later.

A second problem is extending amortizations isn’t available to everyone. Generally, you need to have 20% equity in your home before a lender will consider this as an option. And because most of your mortgage payment goes towards interest rather than principal, just because you made it through 20% of the mortgage doesn’t mean you’ve built up 20% in equity. Under typical repayment schedules (with no extra payments put towards principal), after the first 5 years of a mortgage you will have only built up about 10% equity in your property.

So if this is your first renewal (meaning you are renewing after year 5 of a 25 year mortgage), this option may not be available to you.

Option #4: Sell the House

And finally, if no other options work out, you have to sell your house or the bank will take it and sell it for you.

This is the option everyone wants to avoid because that’s how housing crashes start, but if there are no other options, this is what happens.

What Homeowners should be doing now

You might be thinking “I have a mortgage, and I’m going to have to renew it soon. Is there anything I can do to prepare?”

Yes. De-leverage.

That means throwing as much money as you can towards your mortgage, either by making extra payments (ask your lender for what options are available) or by doing it at renewal time.

This dangerous situation is caused by everyone being in too much debt. If you reduce the amount you owe, how much danger you’re in goes down as well.

By saving up cash and using it to pay down your balance, your payment will be reduced, hopefully by enough to offset the interest rate increase. And if you can get your equity levels to hit 20%, that’s even better because it gives you the option to extend your amortization. When it comes to dealing with issues like this, more options is definitely better than fewer.

Conclusion

Mortgage renewals, in normal times, are usually a non-event. Typically, your lender sends you a form and you just sign it.

However, these are not normal times. How mortgages get renewed over the next 5 years will determine if Canada manages to avoid the USA’s fate of a Financial Meltdown. Some factors are in Canada’s favour, like the lack of NINJA loans. But other factors are clearly against us, like the fact that 100% of our mortgage market is ARMs versus the 13% market share that toppled the Americans.

No matter what we do, some people who bought too much house at too-low rates will lose their homes and be forced into bankruptcy come renewal time. The big question is whether the mistakes of the greedy will end up bringing the entire system down.

What do you think? Do you think Canada’s heading in a US-style housing crash, or will we be able handle higher interest rates without the mass foreclosure the Americans saw? Let’s hear it in the comments below!


Also, in other news, there’s a new FIRE documentary called “Seeking FIRE” out, and we’re in it!

It’s available on ITUNES in the US via this link. They’ll also have a screening at the prestige Hot Docs Ted Roger cinema in Toronto on August 17, 2023. Get your tickets here.


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35 thoughts on “The Mortgage Renewal Trap”

  1. I was just stunned a few years back when I learned about Canada’s version of a “fixed rate mortgage”. I seriously don’t understand how younger Canadians can sleep at night. Financial planning is also surely more difficult.
    I don’t understand the rationale behind these funky limited options.

    1. I agree. I think the mortgage market is similar in the UK with 5 year “fixed rate” mortgages being the norm.

  2. You have spoken of a potential Canadian housing crisis for a long while now. Eventually you will be right.

    1. It’s looked like an unsustainable house of cards for my entire working life. I have no idea when, but it’s got to correct at some point.

  3. I have wondered when this all is coming to an end and how people are affording these crazy home prices on top of the interest rates. Maybe if it crashes I can finally buy a home….sad state of affairs

    1. They’re not. Many of them are wishing SUPER HARD that interest rates return back to 0% before their renewals. It’s…not a great system.

  4. Thank you for this very clear article! We are very curious too to see what will happen in the next 5 years, whether the house prices will come down, and by how much. We are well on our way to be FIRE, and we are tired of home lovers being coddled by the current Canadian rules to avoid their dismay.

    1. That’s a great point. In this country, home owners keep getting treated with kid gloves by the government, and it just keeps making houses more expensive. We have to let over-indebted homeowners fail so they see real estate is not a riskless investment.

  5. Our 5/5 renewal came up a few months ago in February. Painful. We sucked it up. Where we live in rural Nova Scotia renting is not an option; more vulnerability than owning. Even if there was a crystal ball, not sure I’d want to look in it.

    1. Haligonian here. Rent and housing prices are awful in the city, the houses are not worth what people are buying them for. Myself, I just resigned my lease for a 4th year for my 2bed 1.5 bath for $1,725 /month which is a STEAL now. Same thing down the street is $2,400.

      I will not be leaving anytime shortly, until, I believe this crash will happen in the next 2-3 years.

  6. In your opinion, how does Canada’s policy on welcoming 500,000 immigrants a year impact the housing market? Will it continue to prop up the market and prices of homes?

    1. As a 2nd generation immigrant, I’m a little biased in defending my fellow immigrants. However, housing in Toronto and Vancouver has gotten so expensive that some of them are returning back to their home countries because the cities are too unaffordable.

      House prices seem to be primarily determined by interest rates and domestic demand, rather than foreign buyers.

  7. It’s a good time for those of us who ‘own the bank’ with shares instead of ‘working for the bank’ with increasing mortgage payments.
    Only thing is with all these FIRE people who rent, it will be a knock on effect of condo investment holders passing on the increasing costs with increasing rents.
    No Canadian bank will implode as the government is guaranteeing all the loans through CHMC.
    I doubt Canada’s housing market will decrease much as shown through the Cullen Report in BC, Canada’s housing market is supported by no enforcement of transnational financial crimes. Canada is the wild west and doesn’t enforce laws against money laundering, fraud, tax evasion in the housing market. $Billions a month is flowing in from all over the world. The source of the money much of it criminal and ill gotten is never reported. There are no laws against bringing in suit cases full of cash into Canada.

    1. Yup, as a bank share owner I’m watching my dividends increase and I’m loving it!

      However, I never did understand our government’s hesitation in tackling illegal cash flowing into our real estate market. Invest money into investigators to go after them! It’s the best money we’ll ever spend.

  8. Bought a house in Southern Ontario in 1989 near the top of the market. First mortgage had term of 2 years with a interest rate of 13%. Renewed mortgage 2 years later for 5 years at 11%. Fortunately I had a 30 % down payment and the modest house only cost $135k.

    With first mortgage payment, I noticed only about about 8 percent of the payment went towards the principle. With both mortgages, I was allowed to make extra monthly payments. Lived very frugally and tried to make extra payments every month to reduce the principle amount. And did not do any major renovations as the house was dated but in ok condition. Paid off house in 7 years.

    I believe very low interest rates distort the price of a house and reduces the urgency of paying down the mortgage.

    1. “Paid off house in 7 years.”

      Wow, that is impressive. Congrats! Unfortunately, none of my millennial friends who bought in the past few years will ever achieve this…

  9. Wanderer, I wonder what your thoughts are regarding Canadas ability to deal with this crisis when our interest rates are essentially forced to somewhat keep lockstep with rates in the US. I understand that the bank of Canada sets their own rates independent of the US fed, but having too much of a divergence from the rates south of the border can have a massive effect on other parts of the economy such as strength of the Canadian dollar, trade, international investment etc.. The way I see it is the US faces less risk of massive defaults because people are legit locked in to the 30 year rates and the fed will have less reason to drop rates in the next few years as less homeowners will be in trouble. If canadas rates need to stay somewhat in lockstep with the US they may actually need to stay higher for longer than required even once the majority of mortgage holders in Canada have renewed into the higher rates. This presents a very interesting dynamic in my opinion, will the Canadian real estate market basically be at the mercy of the decisions of the US fed?

    1. That’s a great point, and I agree. The BoC has one hand tied behind its back because of our dependence on trade with the US and the need to keep our currency within a bounded range, and since inflation in the US seems to be stickier than up here, our interest rates will likely stay high for many years to come. That’s why I think the home boners’ belief that interest rates will come down in the near future is just wishful thinking.

  10. I think Canada will be fine. Something like 60% of homes are mortgage free. Some of the ones with mortgages will get crushed with bad timing but that’s even a smaller chunk of houses. It’ll be ok but there will be some horror stories of people losing their homes at renewal time. Not enough to impact the market overall.

    1. I hope you’re right, but we’ll see. If we can spread out the stress over many years and keep foreclosures from sprouting up everywhere, we should be OK…

  11. It’s interesting to see how different countries have varying approaches to mortgages. In France (where I come from), all mortgages are fixed rate for the entire duration of the loan, which provides stability and peace of mind for borrowers. I was surprised when I moved to the USA and discovered their system of fixed mortgage rates, and now it seems Canada has a similar situation.

    Why not advocating for fixed-term mortgages throughout the entire loan period in Canada. After all, fixed rates can protect buyers from sudden payment increases and potentially prevent them from ending up in difficult situations.

    Wanderer, do you know why Canadians haven’t been pushing for this change to provide more security for homeowners and avoid any potential payment shocks down the line?

    1. I have no idea, but to be honest it hasn’t been an issue until now because interest rates have never risen this fast before. I suspect that once enough people lose their shirts during this rate tightening cycle, there may be more political appetite towards reforming the mortgage regulations.

  12. US home buyer here, with a fixed rate mortgage. My monthly payments have gone up, not because of my mortgage, but because of the increase in property taxes and home owner’s insurance. So even with a 15 year fixed rate mortgage, there are going to be added costs and then repairs needed. The costs of owning a home are more than just the mortgage and folks need to be aware of that too. I have already spent at least 7K this year on repairs and upkeep.

  13. I have to take issue with the “scrupulous secondary lenders” comment. I was a mortgage broker back in 2004-2005. I did a lot of ARMs, NINJA loans, stated income, 125% LTV loans with no down payments, etc. Yeah, they were loans that had no business being written, and the lenders were stupid to do them.

    But, what nobody mentions is how insane borrowers were at the time too. I worked on 100% commission. If I didn’t close loans, I didn’t get paid. Almost every single borrower would comment, “if you can’t close my loan, I’ll just find someone who can.”

    Lenders were definitely out of control, but so were borrowers.

  14. Hello! It’s been a long time since I commented on here but I used to comment a lot and then I fell out of the habit of checking the site during the pandemic and I wasn’t getting the notification emails when new articles were posted.

    I hope you guys are well! I’ll have to go back and read of bunch of the old posts I missed.

  15. Hello, thank you for all your posts! I am in Canada, and was about to buy a house… decided otherwise : ) — so if I maxed out my RRSP, TFSA and FHSA, if I have a big lump sum lying around, do you recommend I just put it in a Margin account @ 60/40? I guess with a large lump sum, you can invest a portion of it every 2 weeks or so, over a period of a year?

  16. I guess in the Netherlands 10 yrs fixed rate is the most common. We have a 20 yr fixed rate. Also you need to make payments to the principle for a tax advantage.

  17. Interesting times, in Australia our system sounds very similar to Canada’s.

    Last few people will be coming off there covid 2020 fixed rates by July 2024.

    I feel very happy that I live below my means and have been paying alot extra into the Homeloan since 2018.

    Now will most people are stressing about interest rates, I have $25,000 left to pay off by January 2024.

  18. Once a recession hits you will see rates “normalize”. It doesn’t take a genius to see that Canadians are more at risk this time and rates have been accelerated too much too fast… I would expect rates could settle in the 3 to 3.5% range, if we are lucky. The BOC got it wrong during the pandemic, and every other time, so why do you think they magically got it right this time?

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