The hottest type of home equity line of credit is in the crosshairs of Canada’s banking regulator, which is seeking to rein in risky borrowing as rising interest rates put additional pressure on homeowners heavily in debt.
The product under consideration is the re-startable mortgage loan, ie a traditional mortgage loan combined with a line of credit which increases in size as the customer pays off the principal of the mortgage loan. The regulator, the Office of the Superintendent of Financial Institutions (OSFI), calls them combined mortgage-HELOC programs, or “CLPs,” and is watching them cautiously because they have exploded in popularity as home prices soared.
In the first two years of the COVID-19 pandemic, repayable mortgages grew 34% and combined loan products had a total value of $737 billion in the first quarter of 2022, Bank data shows. from Canada. This represented 42% of all secured residential loans, up from 37% in the first quarter of 2020 and 36.5% during the same period in 2019.
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This sharp increase caught OSFI’s attention. In a speech in January, Superintendent Peter Routledge said repayable mortgages now account for “a significant portion of uninsured mortgage debt of Canadian households.” And while he acknowledges that they can be useful financial tools when used responsibly, Mr Routledge said “they can also create vulnerabilities” for the financial system and increase the “risk of loss for lenders”.
OSFI said it would announce changes to the rules governing these products this spring and highlighted two main concerns. The first is that the ability to borrow home equity after each principal payment has the potential to keep customers deeply in debt.
The other is that HELOCs can be used to mask any cash flow problems a borrower may have, making it harder for lenders and regulators to detect impending problems, especially in times of crisis.
In a speech last November, Mr. Routledge suggested that OSFI could force banks to classify repayable mortgages as riskier loans, which would make them more expensive for lenders to keep their books, because they would have to put set aside more capital for each loan. . He also said the regulator could tighten rules on how lenders underwrite these loans.
Bankers and mortgage industry experts say the regulator could also limit how much homeowners can borrow against their homes or force them to requalify for increases in their HELOC.
These changes could help curb some of the more precarious borrowing, but it’s not clear they would significantly slow demand. Experts say banks would likely pass on the higher capital costs of these mortgages by charging customers higher interest rates.
“It would increase costs for lenders, in which case the pricing strategy for these types of products would have to be recalculated for all lenders,” said Maxime Stencer, director of mortgage lobby group Mortgage Professionals Canada. “If there are more costs involved in making this product and owning this product, then it becomes more expensive to supply it to customers, so customers would likely be affected.”
Forgivable mortgages are now a commodity for most major lenders. Banks are promoting them as a powerful borrowing tool that allows customers to easily access the equity in their home.
A website promoting Bank of Montreal’s Homeowner ExpressLine succinctly presents the concept of an adjustable mortgage: “Apply just once. Borrow some. Pay some back. Borrow again. Pay off your mortgage. Borrow even more.
Other banks branded their recancellable mortgages with punchy names like TD’s Home Equity FlexLine and CIBC’s Home Power Plan. Spokespersons for Canada’s five largest banks declined to say what proportion of their overall mortgages these products represent.
But regulators say the products also risk allowing customers to spend beyond their means and rack up lingering debt that can make them more vulnerable in an economic downturn.
As national home prices soared late last year, Routledge said in November that the ability of homeowners’ mortgages to increase their borrowing “can simultaneously fuel and help Canadians allow home valuations to rise. Homeowners can borrow against lines of credit tied to their existing homes to purchase vacation and investment properties.
Today, the housing market has cooled considerably due to rising mortgage rates. Economists predict that the typical price of a home in Canada could drop by double digit percentages this year.
This would reduce the value of a homeowner’s property relative to the size of their mortgage and bring them closer to a level of debt that OSFI considers troublesome: borrowers who owe their lender more than 65% of the of the house, also referred to as a loan-to-value ratio (LTV), which is a key measure used to assess risk in the financial system. A higher ratio represents a high level of indebtedness which could pose more problems for the financial system.
“This subset of borrowers who owe more than 65% LTV pose the greatest risk,” OSFI spokeswoman Carole Saindon said in an email this week.
According to Bank of Canada data, borrowers above this threshold accounted for 28% of combined outstanding mortgages in the first quarter of this year. In the first quarter of 2020, the percentage was 42%.
It’s unclear whether that level of high-risk borrowing has fallen because house prices have risen dramatically or because borrowers were pulling smaller amounts from their HELOCs.
Either way, with house prices beginning to cascade, lower prices will put upward pressure on homeowners’ LTV ratios.
“It is essential to note that these figures are calculated on the current market value of the houses and are subject to change as the market evolves,” Ms Saindon said. “If house prices pull back from these peak levels, we expect current LTVs to increase and the upper 65% portion to also increase.”
This means that borrowers could suddenly find themselves with a much higher ratio. If they exceed the 65% LTV threshold on the HELOC portion of their combined loan, they will be required to begin repaying a portion of the HELOC principal. For borrowers who are stretched to the limit, this could wreak havoc on their finances.
Most HELOCs only require customers to pay accrued interest, not the loan principal. And because the loans are secured by the borrower’s home, they generally carry lower interest rates than unsecured debt.
One of the reasons banks like to offer re-adjustable mortgages is because they make consumers less likely to switch to a competitor. It is easy to transfer a traditional mortgage from one bank to another, but a CLP must be fully paid from one lender and re-registered with the new one. This process requires the borrower to pay fees and go through administrative hassles.
It is unclear whether these combined loans pose an imminent risk to the financial system. Bank of Canada data shows that a large portion of customers have relatively low levels of debt. In the first quarter of this year, 41% of borrowers combined had an LTV of 50% or less.
The mortgage industry says OSFI is overreacting. They say HELOCs give borrowers easy access to their home equity at a lower interest rate than other loans such as credit cards, personal lines of credit and payday loans.
HELOCs are commonly used for home renovations, investments in rental properties, to consolidate more expensive credit card debt at lower interest rates, as well as a source of emergency funds if a borrower has need a quick injection of cash.
For example, if a borrower loses their job and no longer has employment income to pay their mortgage, tapping into a HELOC could be a low-cost stopgap measure to make their mortgage payments while they look for another source of income. .
“HELOCs prevent many more faults than they cause. The reason is simple. When times get tough and you don’t have backup cash, repayable mortgages allow you to keep paying your mortgage,” said Robert McLister, Mortgage Broker and Strategist.
What worries regulators is when stopgap measures turn into permanent solutions — a borrowing cycle that the Financial Consumer Agency of Canada has called a “value-extraction debt spiral.” net of a house”.
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