June 30, 2012
EDMONTON, AB, Jun 30, 2012/ Troy Media/ – It turned out to be a brief flirtation. In 2006, 40 year amortization periods were introduced; now, six short years later, the standard amortization period on a home loan is returning to 25 years, driven by a desire to cool a housing market without touching interest rates (that influence the entire economy).
But there are differences worth highlighting between how interest rates and altering credit conditions influence the demand for housing.
Real-estate is a unique good. It’s the largest investment a household is likely ever to make. The return the household gets from that investment is shelter – which Is a necessity of life – and would have to be purchased, in any respect, in the form of rent. Giving Canadians the option to get into the property market instead of renting or having to wait to upgrade their living conditions was no doubt the primary motivation behind the lengthening of the traditional amortization period.
Opting for a longer amortization period wasn’t cheap. Not only did it cost the mortgage holder a higher upfront free, but it also represented tens of thousands of dollars more in interest payments. Households were offered higher credit than they’d normally be offered – but it came at a cost to borrowers – and lenders still had to do their due diligence. Underwriting standards weren’t reduced, as they were in the United States, but the credit limit was increased. (Read our Backgrounder What are the effects of changes to Canadian mortgage insurance on home buyers?)
The theory was that increased household choice through longer amortization periods meant Canadians would have more room to allocate consumption over their lifetime and the higher price charged on the product was designed to compensate the government for taking on the higher risk. A problem, however, was that the choice wasn’t limited to households that were just looking to move faster up the housing ladder. The product also made it easier for some individuals to simply leverage-up and for others to speculate on the housing market.
Even a small appreciation in home values will result in a massive return to a homeowner who is highly levered, i.e. purchasing a home on debt. The size of the potential debt increases the longer the amortization period and the leverage associated with the debt increases the lower the down payment. The changes to the standard amortization period, then, also permitted both an important investment opportunity for many, but separating out speculators/investors from home buyers is difficult.
Clearly the move to 40 year amortizations likely stimulated demand far more than anticipated, as no one in 2006 was equating longer amortization periods as an alternative to lowering interest rate to stimulate demand just for housing (i.e. the flip of today’s argument for going back to 25).
There’s a big difference between how changes to amortization periods might impact housing demand and the impact that lower interest rates has on the demand for housing. The former is truly a trade-off of higher current housing consumption or investment versus higher total interest and other costs, whereas the latter doesn’t entail any kind of trade off, it’s just cheaper or more expensive.
Take the impact of the recently announced shortening of amortization periods. The monthly payment on a $350,000 mortgage at four per cent increased $176 by lowering the amortization five years, but it saved the borrower about $47,000 in total interest. The equivalent jump in monthly payments, keeping an amortization period constant, could be obtained by seeing mortgage rates increase 85 basis points. In this case, instead of seeing the all-in cost of the house decline, it actually increases by a total of $63,000.
If going to 40 year amortizations back in 2006 was about giving Canadians more choice, then going back to the standard 25 year amortization is about recognizing that poor choices can be amplified when combined with record low interest to the point where financial stability is put at risk.
Some wind will certainly be taken out of the home buyer market, especially at the margins with first-time homebuyers, but it was a prudent move.
Will Van’t Veld is an economist with ATB Financial.
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