Trustee in Bankruptcy, Chartered Accountant
The average house price is expected to reach $396,000 in 2014 and $402,000 in 2015 according to the Canada Mortgage and Housing Corporation. And that doesn't even come close to reflecting higher prices in cities like Toronto and Vancouver. Since higher house prices mean larger mortgages, how can we determine just how much mortgage is too much of a risk?
The "cash flow" answer is that if you can't afford the monthly mortgage payment (and property taxes, and repairs and maintenance) your mortgage is too big. The "equity" answer is that if you have less than 10 per cent equity in your house, you are at higher risk of financial problems.
We recently dug deeper into our analysis of everyone who filed a bankruptcy or consumer proposal with my firm, Hoyes Michalos & Associates, and we discovered that insolvent debtors who own a home almost always have a high ratio mortgage:
More than nine in 10 insolvent homeowners had mortgage debt exceeding 80 per cent of the value of their home, the traditional definition of a high risk mortgage. Worse, seven in 10 had less than 10 per cent equity and 64 per cent reported having no net realizable value in their home at all.
A homeowner who files bankruptcy typically has a mortgage equal to 95 per cent of the value of their house. For consumer proposal filers the number is 91 per cent, so 90 per cent appears to be the magic number. Hold a mortgage above that threshold and you are at significant risk of filing for insolvency.
If you have a lot of equity in your house, you can weather a financial setback. If you have a $200,000 house with a $125,000 mortgage and your income drops, you can decide to sell your house, pocket $75,000 (before selling costs), buy or rent a smaller home, and live on the difference until your financial situation improves.
If your $200,000 house has a mortgage of 90 per cent, or $180,000, you have no margin for error. You probably can't sell your house and generate enough money to pay off the mortgage and pay the penalty to break the mortgage, real estate commissions, legal fees, and other selling expenses. The solution is to turn to the use of credit cards and lines of credit to make over-extended mortgage payments and pay your living expenses. That is why, in addition to a high risk mortgage, insolvent homeowners end up owing on average $73,000 in other unsecured debts as well. It is this debt, on top of too much mortgage debt, that becomes the tipping point into insolvency.
These numbers put into question the conventional practice that Canadians can qualify for a high-ratio insured mortgage with as little down as 5 per cent. While Canada Mortgage and Housing Corporation has continued to tighten mortgage insurance guidelines and the Office of the Superintendent of Financial Institutions has proposed further guidelines, the question is are these changes enough? Neither has to date addressed issues like lowering the amortization period below 25 years or increasing the minimum deposit for high risk lenders.
Our results show that any Canadian, with an average income, is significantly at risk if their mortgage surpasses the 90 per cent threshold. Currently the Canada Mortgage and Housing Corporation only requires a 5 per cent down payment for most homes, so I would suggest that federally insured mortgages should require a minimum 10 per cent down payment. While I recognize this would add an additional burden to a home buyer, it will also significantly reduce the number of house related insolvencies we see.
That is my advice to the government. My advice to any individual homeowner is not to rely on the CMHC, or your bank, to tell you what you can afford. There is no law that says you must borrow the maximum amount possible. Crunch the numbers, decide what you can realistically afford, and purchase within your ability to service the mortgage. It's up to you to protect yourself from risk.