The fact that we need to come to grips with is that improving housing affordability means lower prices. There is no way around that, regardless of the strategy implemented to get to that result. As Rob Carrick of The Globe And Mail states, "The only way young buyers will afford houses is if current owners give up some of their gains". Whether or not there is any societal or political willpower to cut home prices is a different question, but this article will walk through one possible approach to do so.
There are three main ways to lower home prices:
Increasing supply - Possible options include building more homes, reducing selling frictions, and levering or increasing vacancy taxes to make sure the homes that are already built are being put to use.
Reducing demand - Freezing non-resident purchases, limiting the number of non-primary residences a buyer may own, and implementing taxes that make homeownership less attractive could achieve this.
Reducing purchasing power - Increasing the stress-test rate, raising interest rates, and lowering the maximum amortization period are the main ways to do this.
The long-term solution is to build more homes, especially the right mix of homes including more purpose-built rentals. But the pace of construction is notoriously slow in Canada and while efforts to improve supply should be continued, the next generation of hopeful homebuyers can't wait for this being the sole solution. Demand-side measures are great in theory but we do not have strong enough data to understand how effective certain proposals would be and they are sometimes very difficult to implement without people finding loopholes. While reducing excess demand and increasing supply are both important, this article discusses how Canada can materially lower home prices by reducing purchasing power - ultimately by reducing the maximum mortgage amortization period below 25 years.
Hopefully, this article can help reframe the question from "Can they do anything about housing affordability?" to "Will/should they do anything about housing affordability?".
Imagine for a moment that there was no such thing as a mortgage or other means of credit, and that the only option home buyers had was to pay the entire purchase price upfront in cash. Do you think home prices would be where they are today? Per Statistics Canada, the median after-tax income of Canadian families and unattached individuals was $62,900 in 2019 and per CREA, the national benchmark home price in June 2021 was $734,500. Say for example a family with the median income of $62,900 grows their earnings by 3% every year and saves 20% of their annual income for a home, it would take 35 years to save enough to afford the June 2021 national benchmark price. Saving for just the down payment then paying the remaining balance over decades is a much different story. Credit is a key driver of economic growth, allowing someone to borrow from their future self and spend some of their future income today that they otherwise would not have been able to spend. A very small group would be capable of paying today's prices if they did not have access to credit, and therefore we can conclude that credit plays a key role in home prices. Supporting this argument is a finding from the 2021 Mortgage Consumer Survey Results which states "When asked if this was the maximum price they could afford on the home just purchased, 65% said yes while 17% preferred not to say". There we have it - at least 65% of those who obtained a mortgage in 2021 borrowed as much as they could, meaning that the maximum amount of available credit determined the vast majority of home purchase prices in 2021.
Now that we know home prices are significantly impacted by the maximum amount of credit that consumers can access (cash available for a down payment is the second factor), let's understand where that number comes from. Lenders are trying to make a profit and they do so by collecting the spread between the interest rate a borrower pays them and the interest rate they themselves are paying to borrow. Because of this structure, the most profitable arrangement for a lender is to issue the highest possible amount of credit where the borrower is able to make recurring payments. A buyer's ability to make monthly payments is dependent on a number of variables, including income, interest rates, amortization period, other recurring costs, and existing debt obligations. Out of these variables, the only two which can be influenced by policymakers are interest rates and the amortization period. The stress-test also impacts purchasing power but it is already set far above current interest rates and it is widely expected that actual interest rates will not approach the stress-test levels and time soon. Credit scores also play a role but there is no ability to manipulate this for the purpose of lowering home prices without also shutting out the younger generation. Lower interest rates increase borrowing ability, as less money is needed to pay interest, and therefore more can go towards principal payments. Ratehub.ca shows historical interest rates declining since the mid-1980s and we have seen the correlation in home price growth during this same timeframe. Longer amortization periods have a similar effect, by allowing a borrower to repay the mortgage over a longer period of time. Based on this understanding, this means that the two ways to reduce purchasing power are by increasing interest rates or by shortening the maximum allowable amortization period.
Many who have been following Canada's housing market have been calling for the Bank of Canada to raise interest rates. This is a reasonable suggestion as rock-bottom interest rates paired with quantitative easing have resulted in market conditions where money is cheap and investors are forced to move up along the risk spectrum as bonds are yielding low or negative real interest rates. However, as stated by the Bank of Canada, "Interest rates affect all parts of the economy and are too blunt an instrument to address an imbalance in just one part of the economy". Raising interest rates would certainly reduce purchasing power, but the impacts on the rest of the economy need to be weighed carefully as well. This leaves us with the second option - reducing the maximum amortization period.
The typical mortgage amortization period in Canada is 25 years, but where did this number come from? Every country has different lending practices, including the maximum amortization periods that are allowed on mortgages. Some examples per OECD are shown in the chart below and we can see that most countries have a typical amortization period between 15 and 30 years.
RateSpy has been tracking all changes to Canada's mortgage rules since 2004, and below we summarized the historical changes to the maximum amortization period, alongside benchmark home prices and discounted 5-year fixed mortgage rates. The green lines represent increases to the maximum amortization period while the red lines represent decreases.
Note that the above changes all apply to insured mortgages only (we'll discuss the importance of this fact later). If a buyer does not make a down payment of at least 20%, the mortgage must be insured by CMHC or one of its two private competitors - Sagen (formerly Genworth MI Canada) and Canada Guaranty. While the maximum amortization period hasn't changed since 2012, this is something that used to be adjusted quite frequently. Per Financial Post, OSFI became responsible for reviewing and monitoring the safety and soundness of CMHC’s commercial activities in 2012 (largely its mortgage insurance and securitization programs). Prior to this, CMHC was overseen by the Human Resources Minister. CMHC introduced the first four changes, while the Department of Finance directed the reduction from 35 years to 30 years and OSFI directed the reduction from 30 years to 25 years.
As discussed earlier, falling interest rates and shortening amortization periods have the opposite effect on home prices. From the first increase in February 2006 to the first decrease in July 2008, purchasing power increased by approximately 21% due to the amortization rule changes alone. During this time, mortgage rates fluctuated between approximately 5% and 6% and home prices increased by $70,000 (26% change, or 10% annualized). We see the first decrease to amortization periods in July 2008, which was followed by falling home prices for over one and a half years. During this same time, interest rates fluctuated heavily but were declining. Of course, this is when we had the financial crisis, so that was another key factor influencing home prices at the time. In April 2009, home prices began rising again and interest rates continued declining - as they have done up to the present day despite two further reductions to the maximum amortization period. The most recent change from 30 years to 25 years was followed by a six-month decline in home prices while mortgage rates were still falling, but this didn't last as the amortization period became static thereafter and interest rates continued to fall.
We should consider reducing the maximum amortization period from 25 years to 20 years. This direction would need to come from the Office of the Superintendent of Financial Institutions (OSFI) and the Department of Finance. OSFI reports to the Minister of Finance, Chrystia Freeland, and regulates and supervises more than 400 federally regulated financial institutions including CMHC and its two competitors. OSFI has been heavily involved in mortgage regulations in the past, including introducing stress-test changes and capital requirement changes. CMHC could not introduce this change on its own as its competitors do not always follow suit. Just recently, CMHC tightened its underwriting practices, and neither Sagen nor Canada Guaranty did the same. Financial Post notes how this resulted in a significant drop in CMHC's market share, and we can assume the same would happen if CMHC were to reduce amortization limits on its own.
Reducing the maximum amortization period has the following benefits for home buyers:
If successful in reducing home prices, less cash is required for a down payment, which has become a significant barrier to entry for homeownership.
Buyers would pay off their mortgages over a shorter time and have more cash flow later in life.
Less interest is paid over the life of the mortgage. Using the previous example with the June 2021 home price and mortgage rate, the total interest paid over the life of the mortgage would be $165,000. Total interest payments would be reduced to $130,000 for a 20-year mortgage and $97,000 for a 15-year mortgage. In reality, the interest savings would likely be even higher as home prices would fall.
Potentially less competition from investors who are looking for properties with positive cash flow and are no longer able to use 30 or 35 year mortgages to achieve this.
You may be wondering - if reducing the maximum amortization period didn't significantly impact home prices in the past then why would it work now? Here are five reasons:
Interest rates are already close to zero, so there is not much room for further decline. This major component of purchasing power has been falling for 40 years and these declines can offset the impact of decreases to amortization limits.
More buyers are opting for the maximum amortization period now than in the past. Per CBC, the Candian Association of Accredited Mortgage Professionals estimated that about 40% of all new mortgages were amortized over 30 years in 2011. Per the 2021 Mortgage Consumer Survey, 45% of first-time buyers and 51% of repeat buyers have amortization periods of 25 years and above.
Previous amortization period limits were implemented for insured mortgages only. As uninsured mortgages can still have amortization periods of 30 or 35 years, a reduction below 25 years would substantially reduce purchasing power. Many investors are likely taking advantage of 30 or 35 year amortization periods in order to maximize monthly cash flow on their properties. If properties are cash flow negative on a lower amortization period this could also remove some investor demand from the market.
The change in purchasing power when you go from 25 to 20 years is more significant than going from 40 to 35 years (or 35 to 30 years). Lower interest rates actually amplify the impact of amortization period reductions as well. Here is an example of how the amortization period impacts purchasing power. If we take the June 2021 national benchmark price of $734,500 as the loan amount and the current discounted 5-year fixed rate of 1.68%, the monthly mortgage payment would be $3,000. If the mortgage was amortized over 20 years instead, the same $3,000 monthly payment would result in a loan of $611,200 (or a 17% reduction). At 15 years, the same $3,000 monthly payment would result in a loan of $477,000 (or a 35% reduction).
While home prices have been rising for decades, the market has historically been much more balanced. Per CREA, there were 2.3 months of inventory on a national basis at the end of June 2021, up from an all-time record-low of just 1.8 months in March. CREA also notes that the long-term average for this measure is a little over 5 months. When inventory is so low, there is more competition amongst buyers and this can result in buyers bidding the maximum possible amount they can afford. As noted earlier, 65% of buyers in 2021 paid the maximum they could afford while another 17% preferred not to say. In a more balanced market, there would be much less need to borrow the maximum qualifying amount. Therefore, cutting purchasing power may not have been as impactful as it would be when leveraging to the hilt is dominating the market.
There will certainly be opposition to this idea. The benefit to consumers of having lower interest payments over the life of their mortgages would be a blow to lenders. There are also many seemingly well-intentioned parties suggesting that increasing the amortization limits is the way to help hopeful homebuyers. The NDP's proposed housing strategy includes increasing the maximum amortization period for insured mortgages from 25 to 30 years. They don't seem to recognize that when the majority of buyers are paying the most they possibly can, increasing the amount they can borrow will drive up prices further.
If Canadians are looking for a way to curb home prices quickly, this may be one of the best approaches to do so. Reducing the maximum amortization period targets home prices directly with as little spillover as possible to the rest of the economy. To maximize effectiveness it should likely be combined with other demand-side measures. As we have seen in the past - if it doesn't work it can quickly be reversed. This move would also finally send the message that policymakers will take the necessary steps to make housing affordable for the average Canadian. It would do wonders to destroy the narrative that the government will just let home prices keep soaring. However, as we opened up this article by stating - work addressing the supply and demand issues will be critical to ensure long-term stability. This is simply a potential stopgap solution to try to address an urgent problem.