In recent years, the Canadian government took action to cool the overheating real estate market by lowering the maximum amortization timeframe from 40 to 25 years for Canadian Mortgage and Housing Corporation (CMHC) insured homes. According to financial and real estate experts, this reduction was out of concern for Canadians burdened with too much debt and a housing bubble.
This reduction in the amortization period has not really cooled the housing market (in particular cities such as Toronto and Vancouver). In fact, it is still hot, hot, hot! With the Bank of Canada maintaining a one-percent interest rate, it is still fueling the desire for home ownership for first-time buyers and allowing others to trade-up on their existing home.
Traditionally in Canada, most mortgage terms with banks are five-year closed. Remember, that the first two or three years, a homeowner is mostly paying the interest on the mortgage. Now, there are opportunities to have one, or two-year mortgage terms, but in most cases it is five year closed. As the five-year term gets close to renewal, banks give the homeowner the opportunity to ‘shop around’ for better rates. On a side note, a homeowner can ‘shop’ at anytime during the five-year term, but if the homeowner moves the mortgage to another institution, they will have to pay penalty fees to the current bank, sometimes as much as $45,000.
During the five-year term, homeowners can rest assured of how much they must set aside each month to cover their household expenses, including the mortgage. But, when it comes close to the term ending, it can become stressful, especially if interest rates rise. Most people usually budget for their home and expenses at the time of the home purchase; however, a lot can happen within the five-year timeframe; for example, unforeseen circumstances, such as a reduced income, a birth of a child, death of a partner, financial trouble, or economic changes in the world. If the budget doesn’t leave room to save for the unexpected, it causes an uncomfortable situation.
On the other side of the coin, banks at the end of the five-year term give clients the option to refinance and that opens the possibility of losing the client to another institution. This doesn’t promote brand loyalty for the bank.
In the United States, financial institutions have provided homeowners with a 30-year fixed rate mortgage. To have this type of mortgage, a homeowner sometimes pay a slightly higher rate than a shorter term mortgage and it takes more time to actually own the home.
However, the homeowner is rest assured of having one consistent monthly payment, because both the principle and the interest are evenly spread throughout the 30-year term. The banks get to keep their clients around and up-sell other services.
There are a few benefits to the 30-year fixed mortgage that could certainly help the Canadian homeowner:
– Over the amortization period of the mortgage, the homeowner knows exactly what their mortgage payment is, because the interest rate is locked in for the 30 years. There’s a sense of security knowing that and the opportunity to weather any number of unforeseen circumstances.
– The 30-year fixed mortgage allows the homeowner to save. The savings can go towards paying down on the principle faster or enable the homeowner to buy other investment products – another win for the financial institution.
– Homeowners are buffered from fluctuating interest rates, caused by an unpredictable or volatile marketplace. However, if the rate is lowered from their existing rate, they have the option to refinance the loan – no different from in the U.S.
It is not clear why Canada doesn’t offer a 25 or 30-year fixed term mortgage like the US. Some speculate that it’s not profitable enough for the Canadian banks. There may be other reasons required by the government. However, the advantages of the 30-year fixed term would certainly provide a peace-of-mind experience for the homeowner, provide a stable real estate economy and make banks look more favorably in the eyes of their clients. It would be beneficial for Canadian homeowners to ask their banks for 25 or 30-year full amortized mortgages. It may not be easy to get it, but if more people ask, institutions will have to eventually make changes.
It is only fair to discuss the partial amortized (five-year term) mortgage, because it has advantages too.
– It’s a great way to buy a home for lower initial payments than a fully amortized loan, which allows the homeowner’s net income to be higher.
– Often, partial amortization loans require regular payments on the interest and principal, with the remaining balance to be paid at the end of the term, or refinance into another five-year term.
As always there are disadvantages and a homeowner must realistically consider their own personal circumstances. A partially amortized loan is a risk for both the homeowner and financial institution:
– If interest rates move substantially higher for a partially amortized loan the home owner monthly cost will increase. In the event that circumstances change and a homeowner cannot make the monthly payment on the mortgage as planned, there’s a risk of defaulting on the loan.
There is also another solution that provides Canadian homeowners with an alternative to the traditional mortgage. It is known as 100% HELOC or Home Equity Line of Credit. The benefits of this alternative are:
– The interest rate is usually prime (variable bank rate) plus or minus.5 percent
– It is an interest-only loan and there are no penalty fees to pay off the loan at any time.
– Because it is an interest-only loan, during tough economic times, a borrower will be required to only pay the interest on the loan.
– As the equity increases in the home, credit on the loan also increases, giving the home owner access to the equity at little or no cost.
– It doesn’t take much to negotiate a lower interest rate, just call your bank and ask.
– There’s no need to have a saving account with 0% interest paid to you monthly, just deposit all your extra funds on the line of credit and enjoy the real savings on the mortgage rate.
– Withdraw funds at anytime to purchase your second home or investment property, without your bank’s approval.
While the pros to this alternative outweigh the con, it is very important to know what the con is to avoid disaster:
– 100% HELOC is very flexible – maybe too flexible. Homeowners can get into financial trouble by borrowing more than they need to. Make sure to have sufficient equity in the home already and follow a discipline budget when spending.