Imagine it: You buy a house, and the bank offers you a single rate of interest that will keep your mortgage payments steady for the next 30 years.
Pay it off early if you like, by the way: no big penalties to fear.
And if interest rates drop sharply, you can refinance that loan to take advantage of lower monthly payments!
That’s a (very general) explanation of how the bulk of mortgages work in the United States.
And the federal government just signalled it’s curious about bringing that model to Canada.
The fall economic statement tabled on Monday included a short reference to the idea of making long-term mortgages more widely available in Canada.
Under a section on “lowering the costs of homeownership,” Ottawa said it was “examining the barriers” to making mortgages with terms of up to 30 years available — a way to offer more options to borrowers. The federal government now plans to launch consultations to explore bringing these long-term options to the mortgage market.
But experts tell Global News it’s a model so far unique to the U.S. housing market — some have called it a “Frankenstein’s monster” of a mortgage — and warn bringing such a product to Canada would be no easy task.
On top of that, some say those changes might not make the housing market any more affordable to would-be buyers.
“Most fixed-rate borrowers say they want U.S.-style mortgages… until they see the price tag,” Robert McLister, mortgage strategist with MortgageLogic.news, said in an email.
How are the Canadian and U.S. mortgage markets different?
You might already be familiar with the structure of Canadian mortgages, but here it is in a nutshell.
When a homebuyer applies for a mortgage, the typical process sees them take out a loan to be paid back — or amortized — over 25 years, though Ottawa has recently implemented changes making 30-year amortizations more accessible.
Within that 25- or 30-year period, the mortgage is broken up into different terms. Canadian homeowners will often take on a mortgage with a fixed rate of interest for five years or fewer.
At the end of those five years, the rate of interest will change based on market conditions at the time of renewal, and the term will begin anew until the homeowner has paid off the entirety of the loan or broken the mortgage.
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There are also variable options that see the rate of interest fluctuate directly after the Bank of Canada’s decisions to raise or lower the cost of borrowing. Those also have set terms that typically renew after a few years.
But as described above, in the U.S., the most popular mortgage option by far is a 30-year fixed mortgage: one rate of interest for the entirety of the loan. Homeowners can still refinance if interest rates drop and they’re willing to pay a fee to take advantage of lower monthly payments, but there’s usually no requirement to renegotiate terms with a lender over the course of the mortgage.
This, by the way, is one of the main reasons that interest rate hiking cycles like the kind Canada and the U.S. have both been through in recent years are more impactful on Canadian households, because they’re more often renewing their mortgage terms in the new environment and adjusting to higher payments.
Variable options also exist in the U.S., called adjustable-rate mortgages. These will have the rate of interest adjusted annually for the remaining lifetime of the loan, sometimes after an introductory fixed period.
In the U.S., most mortgages are also fully open, which makes it easier to pay off early without penalty. In Canada, however, most mortgages are closed and fixed with set conditions for when you can accelerate payments, and these tend to come with lower interest rates.
Oh, and speaking of penalties: because of how Canada’s financial system is structured, McLister noted that lenders can only charge penalties worth up to three months’ interest if a mortgage is terminated early after the first five years.
“Barring a change to Canada’s Interest Act, lenders would bake borrower pre-payment risk into the rate,” he said, thereby making mortgages more than five years in length more expensive.
And not to get too far in the weeds, but breaking that more expensive mortgage within the first five years would also be pretty costly for a homeowner.
“There would be harsh early-exit penalties for people who break 30-year fixed mortgages early before five years, given how interest rate differential charges work,” McLister said.
Why can the U.S. offer these 30-year mortgages?
OK, we’re going to try to keep the jargon to a minimum here, but stick with us.
If you’re the lender, and you’re offering a single loan at the same rate of interest for 30 years, there are many reasons why that is maybe a not-so-great business decision. A lot can change over 30 years, and if central bank interest rates rise and your borrower is still paying that lower mortgage rate, you’re essentially losing money.
Not to mention, there’s a risk that the person you’re lending to has a major change in life circumstances like a layoff that affects their ability to pay you.
Shubha Dasgupta, CEO of Pineapple Mortgage, explains to Global News that there’s a “risk premium” attached to longer mortgages to account for these unknowns at the time the loan is being offered.
U.S. mortgage rates are indeed typically larger than Canadian ones — as of Wednesday morning, the typical mortgage rate on offer in the U.S. was around 6.6 per cent, while Canadian fixed-rate products are floating around the mid-to-low-four-per cent range.
But to account for all of that risk in a 30-year product, the rates in the U.S. really should be astronomically higher.
Here’s where we come to the key difference in the two mortgage markets that makes it viable for U.S. banks to offer affordable 30-year mortgages: Fannie Mae and Freddie Mac, two government-backed entities that have a big role to play in keeping the housing market running south of the border.
These two government-sponsored organizations buy up mortgages from lenders, package them together and sell them in financial markets as mortgage-backed securities.
Dasgupta explains that this frees up capital for banks to go out and make more loans or fund other operations while still offering American homebuyers what would otherwise be a costly 30-year loan.
This system has underpinned the functioning of the American housing system dating back to the Great Depression and is the reason why most U.S. homeowners can get access to much longer mortgage terms than those seen elsewhere in the world.
Canada does not have a system like this that offers liquidity to banks making mortgage loans, so Canadian lenders have to protect their investment by renegotiating the terms of the loan after a few years have passed.
Would 30-year mortgages be good for Canadians?
In order to offer mortgages with terms of up to 30 years without a government-sponsored system like the one in the U.S., Canadian lenders would be forced to charge extremely expensive rates of interest, Dasgupta says.
“There would have to be some kind of a rate premium attached to these longer terms to be able to hedge the risk of what the interest rate environment could look like over that period of time,” Dasgupta says. “So it essentially ends up costing more for Canadians.”
He adds that, if the 30-year mortgage options were even being considered, the Canada Mortgage and Housing Corp. and other insurers would likely have to play a big role to mitigate the risk for lenders offering such a long term.
“It would just be very risky on their portfolios,” he says.
There have always been trade-offs to be made between stability and cost when it comes to mortgage payments in Canada. That’s one of the reasons why the five-year, fixed-rate mortgage is so popular in Canada, as it has historically hit a sweet spot of offering peace of mind at a manageable cost.
McLister said Canada’s Big Six Banks would have to be part of the charge to implement a U.S.-style model across the country, and he questioned how much of a push they’d make with uncertain consumer demand for longer-term mortgages.
“I wouldn’t expect significant uptake for one simple reason: 30-year rates would be materially higher than your run-of-the-mill five-year fixed,” he said. “And if policymakers don’t solve the penalty risk problem, that shrinks the potential market even more.”
While the U.S. mortgage market seems more consumer-friendly in terms of both the long-term stability and the flexibility offered by 30-year, open mortgages, Dasgupta argues that Canadians do benefit from a series of shorter terms with typically more manageable rates of interest.
That allows homeowners to more easily take advantage of positive shifts in the market without having to go through the hurdles of completely refinancing the mortgage, he says.
Renewing every few years gives lenders a chance to make sure a borrower’s credit is still suitable for the terms of the loan or make adjustments as needed, and offers Canadians relief that while the good, low-rate days may not be here forever, the bad times hopefully won’t last either.
“I definitely think that there’s a benefit to having (this system) for both the consumer as well as the industry as a whole,” he says.
A 30-year mortgage with no rate hikes: Can the U.S. model work in Canada?
