CMHC’s ‘interest-only’ mortgage, risks outweigh benefits

Friday, July 21st, 2006

Home ownership: Life on the edge

Harvey Enchin

Buy now, don’t pay until 2016! It’s the kind of pitch you’d expect from a low-brow retailer, not a federal Crown corporation. But Canada Housing and Mortgage Corp. appears to have expanded its role as a conduit for government social policy to shill for the real estate industry.

How else to explain its introduction of the “interest-only homeowner mortgage insurance product” that allows a borrower to pay only the interest on the loan for the first 10 years with as little as a 10 per cent downpayment. CMHC has sweetened the deal even more by extending amortization periods from 25 to 30 years and waiving its high-ratio mortgage insurance application fees.

I don’t doubt CMHC’s good intentions to make home ownership more affordable and accessible but the risks may outweigh the benefits to buyers in such a highly-leveraged arrangement. Home ownership should lead to security and stability, not life on the edge.

CMHC maintains that it must respond to consumer demand with new products in order to remain competitive with rival mortgage insurance providers. But if the private sector is already offering these products — and it is — why does a government agency need to compete? Established 60 years ago to help returning war vets find housing, CMHC has evolved into Canada’s largest provider of mortgage loan insurance. It also guarantees Canada Mortgage Bonds, advises on federal housing policy and delivers programs, including administration of Granville Island.

So CMHC has a full plate without battling for market share against Genworth Financial Canada and GMAC Residential Funding of Canada, two of the largest private companies in the mortgage insurance business, and which, by the way, will insure a mortgage up to 95 per cent of the value of the purchase price. If private companies want to risk their shareholders money lending to borrowers who don’t meet standard debt service ratios, that’s their business. If a Crown agency wants to similarly risk taxpayers’ money, that’s our business.

In any case, the real risk is borne by the borrower, who could wind up homeless if expectations of price appreciation, interest rate levels or cash flow turn out to be too optimistic. After a decade, with little money down and no payments on principal, the buyer could end up with almost no equity in the property, which seems to defeat the object of home ownership.

Even Bank of Canada Governor David Dodge, who knows a thing or two about interest rates, criticized CMHC for backing interest-only mortgages. He argued that they could fuel inflation by raising housing prices, making home ownership less, rather than more, accessible and affordable.

CMHC says the interest-only option will give borrowers “with a proven history of managing their credit responsibly” a lower monthly payment, which will increase short-term cash flow. The key word is short-term. On a $190,000 mortgage at six per cent with a 25 year amortization, a borrower who only pays interest over 10 years will pay $115,700 in interest, compared with $100,600 for a conventional mortgage, according the CMHC figures. When the interest-only period ends, the borrower will then pay a higher monthly payment than would otherwise have been the case because the amount of the blended principal and interest payment must be sufficient to retire the loan within the 25-year period.

CMHC counters that most borrowers who choose the interest-only option will likely pre-pay principal at some point over the 10-years.

This rosy view seems at odds with a Statistics Canada study that showed nearly half of all Canadian households spent more of their pre-tax income in 2001, and that the proportion doing so had risen from 39 per cent in 1982. It added that households that spent more than their pre-tax income were likely to be renters and homeowners with a mortgage.

By the end of 2005, Canadians owed an eye-popping $992-billion, of which 60 per cent was mortgage debt. According to StatsCan, Canadian households carry about $1.08 in debt for every dollar of disposable income. A contributing factor to the increase in debt-financing, it said, was a dramatic drop in interest rates, creating an “easy credit” environment. No money down and no interest to pay for 10 years is a no-brainer when house prices are climbing 50 per cent a year. But what if prices drop? It’s been known to happen. Will the drop become a plunge as thousands of homeowners try to sell properties in which they have no equity?

In the United States, where interest-only loans have been on the market for several years, they have captured up to 15 per cent the residential mortgage business. Of course, Americans can deduct mortgage interest from income tax, which makes it a different ball game.

Jack Guttentag, professor of finance emeritus at the Wharton School of the University of Pennsylvania, warns in an online tutorial that “interest-only mortgages are for borrowers who have a valid use for a lower initial required payment, and are prepared to deal with the consequences.”

In other words, they are not for the average home buyer. Paying down mortgage debt is the surest way for most people to amass wealth. But paying interest without building equity sounds like a financial plan built on a flimsy foundation.

© The Vancouver Sun 2006


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