The Law of Unintended Consequences in Action

The Law of Unintended Consequences in Action




by Union Capital

In an attempt to remove some of the risk in the Country’s housing markets, Finance Minister Bill Morneau recently announced changes to the rules governing mortgage lending in Canada.

Starting October 17, a mortgage stress test is being expanded to cover all insured mortgages – including those where the buyer has a down payment of more than 20%. The test is aimed at ensuring that home buyers will still be able to afford the mortgage if interest rates rise, or if their income drops. Currently, stress tests aren’t required for fixed-rate mortgages longer than five years.

Existing rules require home buyers who take out short-term or variable-rate mortgages with down payments of 20% or less to prove they can afford payments at a much higher interest rate than they’ll actually pay. Meanwhile, borrowers who take out fixed-rate insured mortgages of five years or longer have their income tested against the interest rate that they will actually be paying. The end result is that borrowers can now typically qualify for much larger mortgages if they opt for a longer-term, fixed rate mortgage.

These changes are expected to have an impact on many first-time homebuyers that have less than 20% down payment. These homebuyers will need to qualify for the mortgage based on the five-year fixed rate (currently 4.64%) rather than the contract rate. Since the contract rate is less than the 5-year fixed rate, homebuyers will unfortunately qualify for a smaller loan than before. They may not be able to afford the home that they wanted.

The new stress tests apply only to new mortgages, not renewals.

In the absence of the homeowner coming up with more equity, the possible scenarios come to mind.

• Shift in expectations of homebuyers:
• Demand may shift into lower priced homes and push up the market for those homes.
• Shift to demand for rental housing:
• Those who cannot afford to own a home will switch to rental housing. Increased demand for rental housing may increase the market price for these units.

The changes announced may not cool markets at all.

In the Chinese language, the word "crisis" is composed of two characters, one representing danger and the other, opportunity.

Anytime the government tries to address a perceived problem in the marketplace, unintended consequences appear. The market will always react to stresses to reach equilibrium. We learned this in first year economics.

The following video is a roundtable discussion about how the new lending rules will affect private mortgage lending in Canada.

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