The Wanderer retired from his engineering job at a major Silicon Valley semiconductor company at the age of 33. He now travels the world, seeking out knowledge from other wealthy people, so that he can teach people how to become Financially Independent themselves.
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:
- Give idiots mortgages you know they can’t pay
- Wait a few years until the payments jump higher and they default
- Foreclose on the house to recoup their investment while pocketing their payments
- Profit!
- 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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