Home Prices Are Being Held Down By Canadian Banks' Flexibility

There are ways for Canadians to delay the pain that comes with one of the fastest increases in interest rates in decades, and both the lenders as well as the government have expressed a willingness to maintain the option of extending that period of adjustment.

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As a direct result of the fluctuating interest rates charged by some banks in Canada, some homeowners are adding unpaid interest to the principal of their mortgage instead of paying the full amount each month. Other homeowners are paying only the interest.

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This kind of tactics are becoming increasingly common as borrowers attempt to navigate a massive increase in mortgage rates that has led to a massive increase in costs as well as a decline in property values. Floating rates are particularly problematic in areas like the UK and Canada, which means homeowners are frequently forced to deal with much higher borrowing costs than they would otherwise. Consumers in the U.S. tend to skip over this problem when they look for a 30-year fixed rate mortgage as it is much easier to find one than in the United States.

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In order to prevent defaults and any forced sales, lenders are helping to stave off defaults by allowing borrowers to add interest to the principal or stop paying down the principal every month. However, there are limits at some banks to this, so consumers may find that they are able to adjust to higher costs more easily. 

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Despite this, the problem will only arise when panic strikes, says Arjun Saraf, the chief financial officer at a Toronto-based private lender named New Haven Mortgage Corp. According to the company’s chief financial officer, the problem is caused by panic. In recent years, lenders have become more flexible and aware of the importance of accommodating good-paying borrowers in order to maintain their homes.”

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Hence far, the flexibility has proven to be successful as home prices in the country have fallen nearly 16% and borrowing costs have nearly doubled in the last few months. The Canadian Bankers Association, however, reported at the end of January that there were still only 0.16% of loans outstanding that were in arrears, meaning they were behind on payments by three months or more.

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As the Canadian housing market regains its footing due to a lack of distressed sales, Canadian home prices are beginning to recover. It was the tightest national market since April 2022 in February due to a lack of new listings. More recent data from Toronto, Canada's largest city, and Vancouver indicates prices are beginning to rebound as the scarcity of supply becomes even more apparent.

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In response to the banks' approach to their borrowers, Steve Saretsky, a Vancouver-based real estate broker, said, “We’re extending and pretending.” As far as the distressed inventory in the housing market is concerned, banks are saying, “We don’t really care, just extend it — just loop it onto the balance.” That is actually depressing the distressed inventory.

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There is a possibility that the number of houses that would otherwise have come up for sale may be further limited as the banks have signaled their intention to accommodate borrowers once their mortgages come up for renewal. It is likely that the government will soon be taking steps to ensure they do. Last month, Canadian regulators released draft guidelines for banks to comply with the rapid rise in borrowing costs. They explicitly stated that lenders should help mortgage holders avoid delinquency when they were making their loan.

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Time to be careful

The flexibility in the system is actually helping both sides of it to avoid bigger problems in the future. Whenever there's a large amount of inventory on the market at once, property values may decrease further, making it difficult for banks to get their money back if a default occurs by selling the houses themselves. Borrowers do not want to lose their homes and too much inventory hitting the market all at once could lower property values further. It is also expected that the Bank of Canada will cut the benchmark rate before the beginning of next year, so the situation might also improve. 

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If this doesn't happen within a short time frame, the chances of complications are much higher. As a result, borrowers may have to shoulder a heavier financial burden each month as new payments are calculated based on a higher principal amount. The financial turmoil in the US and Europe has already rattled banks, and if mortgage books continue to increase in risk, banks will also be faced with higher costs themselves. 

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The CIBC Canadian portfolio, which has around $52 billion ($38 billion) of variable-rate mortgages, was about 20% of that amount as of the end of the fiscal first quarter ended January 31, when the borrower's fixed monthly payments had become insufficient to cover interest. When the unpaid amounts are added to the principal, a process called negative amortization occurs, which causes the loan to grow rather than shrink as borrowers repay it.

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The new policy will make it even more difficult for consumers to repay the debt, and CIBC expects that many of those mortgage loan amortizations will take well over 30 years to be repaid.

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A variable-rate borrower at Toronto-Dominion Bank or Montreal Bank can also extend the time period in which the debt must be repaid in order to extend the length of the loan. As of this year, about 30% of each bank's Canadian mortgage books were occupied by loans that were longer than 30 years in the first quarter, up from about zero in the same period in the previous year. It has been estimated by the banks that much of this growth is the result of floating rate loans that are currently subject to negative amortizations.

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There is no negative amortization allowed by Royal Bank of Canada, but variable-rate borrowers may be able to extend their amortization periods to over 30 years and stop paying down the principal each month. According to a spokesperson for RBC, about C$75 billion worth of mortgages, or about 20% of its total domestic residential loan book, are now paying interest only. 

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A mortgage broker in the Toronto suburb of Oakville, Celia Schneider, says she has been helping clients to find solutions to keep them in their homes by finding solutions that will allow them to live in them as long as possible.

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Limitations on loans

In the aftermath of the 2008 US financial crisis, negatively amortizing mortgages gained a bad reputation as predatory mortgages due to the poor reputation they acquired. As a result, some states have implemented limits on this practice. 

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A negative amortization loan in Canada was not necessarily marketed as a product with negative interest. Rather, these loans are variable-rate loans with negative amortization as a way for borrowers to avoid higher payments in the event of a very large rise in interest rates. Variable-rate borrowers have the option of paying down their debt as a lump sum, or by simply raising their payments in order to avoid going into negative amortization altogether. Toronto-Dominion, Bank of Montreal and CIBC allow their borrowers to do just that, by making lump sum payments or by simply raising their payments.

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It is proposed that the government's guidelines prohibit lenders from charging borrowers an early repayment fee for early repayment if they are doing that to avoid negative amortization, and it will also prohibit lenders from charging interest on unpaid interest that has been added to the principal in order to avoid negative amortization.

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An official of the Canadian Imperial Bank of Commerce has stated that the principal of these loans cannot rise above 105% of what they were originally offered. Consequently, consumers will simply have to increase their payments or get the principal brought down to the original amount at that point.

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In part because the government stress-tested borrowers to ensure they had the income to handle rates at current levels, the banks argue that borrowers should be able to cope with higher costs. It's just a way to give borrowers time to adjust to higher interest rates, such as negative amortization or suspension of principal repayments in RBC's case.

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A spokeswoman for RBC and CIBC said that the vast majority of borrowers facing this issue will be able to adapt to their higher payments and eventually repay their loans, according to the spokespeople for each company. 

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During a recent study conducted by Murtaza Haider, a professor at Toronto Metropolitan University who specializes in real estate management, it was clear that the banks were doing their customers a favor. The majority of mortgage borrowers would prefer a negative amortization over paying the extra $500 each month in mortgage costs, if you were to conduct a survey of them.”

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In many cases, borrowers are concerned about what will happen when they have to renew their mortgages. As a result, the amortization typically returns to where it started, resulting in higher monthly payments. According to Capital Economics, nearly 20% of mortgages in Canada are due to expire this year, because terms are typically five years.

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The four banks allowing borrowers to extend amortization periods said they would work with borrowers to find a new method of payment that would be most convenient for them, including extending interest-only payments for a longer period or extending the amortization period permanently. In the government's proposed new rules, loan extensions are allowed, even if they're permanent. However, lenders need to make sure that they don't negatively affect borrowers' credit scores as a result of the extension, and that the time period is reasonable, will offer customers a competitive rate, and won't negatively impact their credit scores.

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Achieving balance

Despite banks' efforts to make sure borrowers are capable of adapting to these higher rates, they may be forced by more stringent capital rules put in place following the Great Financial Crisis to supplement capital as rates rise per the expectation that mortgages may be more risky in the future.

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The Office of the Superintendent of Financial Institutions, the main regulator of Canada's banking industry, said in response to questions about the subject that a higher assessment of the probability of default, or non-payment, would also increase the capital requirements. As a result, they will be able to increase the allowances they are accustomed to receiving as a result of those loans.

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More banks may need to increase capital levels, which may have ripple effects throughout the entire financial system in the event of increasing capital levels. As a result of the turmoil at Credit Suisse Group AG in Europe and the collapse of Signature Bank and Silicon Valley Bank in the US, this would basically increase the cost of doing business for banks, at a time when those costs are likely to be rising anyway. 

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Although regulators, as well as borrowers, may argue that Canadian banks are capable of paying for such loans. There are six largest banks in the country whose deposits and loans make up the majority of the country’s total market share, and they have enjoyed excellent profitability in response to the competition they face from foreign firms because of regulators shielding them from much competition.

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As a result of research conducted by CIBC's portfolio strategist over the five years from 2022, the average return on common equity of these lenders nearly tripled that of the 15 largest banks in Europe. However, in exchange for those profits, the government and regulators expect banks to behave in a flexible manner towards customers depending on the economic circumstances.

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There is a possibility that the bottom may remain under house prices in Canada for as long as the banks are willing and capable of doing so.

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According to Bruce Joseph, the managing director of Trident Mortgage Investment Corp. in Barrie, Ontario, “individuals who wish to hold on to their real estate and ride out this downturn are able to do so,” according to the bank. When banks keep inventory low, they are creating a bit of a price stabilization, and it is certainly proping up the market.