The federal government is cracking down on government-guaranteed mortgages in a move to ensure Canada’s housing market remains strong and, it says, “reduce the risk of a U.S.-style housing bubble developing in Canada.”

New rules, scheduled to take effect on Oct. 15, will limit the maximum amortization period to 35 years from 40 years; require a minimum down payment of 5% instead of 0%; establish a consistent minimum credit score for borrowers; and introduce new loan-documentation standards.

The rules will apply to new mortgages requiring government-backed insurance — that is, mortgage loans for which the borrower has a down payment of less than 20% of the purchase price of the home. Such mortgages must be insured by Canada Mortgage and Housing Corp. or a private mortgage insurer to protect the lender against possible default by the borrower. As CMHC is a Crown corporation, the government is responsible for all of CMHC’s obligations, including its mortgage insurance claims.

WATCHING NERVOUSLY

Canadians who already hold 40-year mortgages will not be affected by the new rules.

Although many mortgage experts generally laud Ottawa’s move, they don’t expect the new rules to make a huge difference in the mortgage market. After all, amortization periods will still be available in the form of 35-year terms.

But there’s no doubt Ottawa has watched nervously as 40-year mortgages, introduced in late 2006, grew in popularity. Finance Minister Jim Flaherty and senior officials at the Bank of Canada have expressed that concern publicly. Some lenders have offered 100% loan-to-value mortgages — mortgages with no down payment — allowing first-time homebuyers who haven’t saved enough for a down payment to get into the market with no money down. Such homebuyers have lowered their monthly payments by spreading the mortgage over 40 years.

Homebuyers haven’t been stopped by the huge additional interest costs involved in long amortizations. According to one estimate, a $250,000 mortgage at 6.5% would cost $445,000 in interest over the 40 years, compared with an interest cost of $252,000 for a more traditional 25-year amortization.

Jim Murphy, president and CEO of the Canadian Association of Accredited Mortgage Professionals, says that during the period from autumn 2006 to autumn 2007, about 37% of all mortgages in Canada had amortization periods longer than 25 years. But Murphy doesn’t expect longer amortizations to disappear once the new rules are in place.

In his view, 30- or 35-year amortizations will become the norm because “the market is responding to a demand.” For instance, borrowers who are not necessarily first-time home buyers may choose to go with longer amortizations to free up money for other purposes.

Just the same, several major banks have announced they will no longer offer 40-year mortgages. First off the mark was ING Direct, which is making the change immediately. Apparently, only about 10% of ING mortgages were amortized over 40 years and the online banking firm did not offer mortgages without down payments.

CIBC, too, is no longer accepting new applications for 40-year mortgages. Rob McLeod, CIBC’s director of communications and public affairs, says those clients who have already been approved for a 40-year mortgage are not affected. But CIBC will still offer 35-year amortizations and a range of other options.

Bank of Montreal is also adjusting its mortgage offering immediately. The maximum amortization period at BMO will be set at 35 years and a minimum down payment of 5% will be required for new mortgages. BMO will continue to process applications from customers who have already applied for a longer amortization or a lower down payment.

Although changes in the rules on amortizations and down payments have received the most attention, there are a couple of other provisions that potential borrowers should note. A consistent minimum credit score will be established and new loan-documentation standards will be introduced. The new rules will also set a maximum of 45% on the total debt service ratio of borrowers; in other words, the proportion of gross income spent on servicing the debt and housing-related fixed or essential payments will not be allowed to exceed this maximum.

MEASURING DEFAULT RISK

A credit score is a numerical value that measures a borrower’s credit risk at a given point in time based on a statistical evaluation of information in the individual’s credit file. According to Finance Canada, credit scores have proven to be predictive of loan performance and are considered by some mortgage insurers and lenders to be the single best determinant of default risk.

@page_break@But, Murphy says, some of the changes — particularly those for loan documentation — are vague and it’s not clear how they will be enforced. The government will be meeting with industry stakeholders to clarify how the new system will work.

Karl Madsen, regional manager for Vancouver and British Columbia’s Lower Mainland with mortgage brokerage firm Invis Inc. in Vancouver, doesn’t expect the new rules will be overly significant to the mortgage market or to first-time homebuyers. For instance, the difference in monthly payments between a mortgage with a 40-year amortization and one with a 35-year span, he says, is about $20 per $100,000 of mortgage.

“A lot of people who took 40-year mortgages did it as a precaution — they needed it as a safety valve,” Madsen explains. Brokers had been recommending borrowers take the 40-year mortgage and immediately use their options — speeding up payments, for instance — to shorten the amortization. But if the borrowers ever got into trouble, he says, they could revert to the original amortization with lower monthly payments.

As for the new requirements for down payments, Madsen maintains mortgages without down payments were not a really popular option anyway. “For years, we’ve had people with 25-year amortizations and 5% down,” he says. “Going back to that isn’t suddenly going to crash the real estate market.”

Overall, Madsen is in favour of the government’s changes. “Paying your mortgage down sooner is better,” he says. “The discipline involved in saving up for a down payment is a good thing for someone about to buy a home.”

Finally, he stresses: “Our market is not the same as in the U.S. We have not been lending to people who just could not pay it back.”

The federal Finance Department confirms this assertion: “In recent years, the percentage of mortgages in arrears for three months or more continues to be at low levels not seen since 1990.” IE