Mortgage interest never as easy to pay as now — as long as rates stay low

It hasn’t been this easy to pay the interest on your mortgage in almost 25 years. Credit rating agency DBRS Inc. has been tracking our ability to pay loans since 1990 and says today we only need on average 3.7% of our household disposable income to cover the interest on those loans — the lowest percentage on the books.

All this comes as Canadians continue to ramp up their mortgage debt, albeit at a slower pace. Mortgages outstanding were up only 5.5% year over year in January, 2014 from a year earlier but still reached $1.2-trillion in the first quarter. That’s a 202% increase since 1999.

The juggling act is pretty simple. The interest costs don’t seem like much when every day there is a better mortgage deal being offered, from the near rock bottom price of 1.99% if you are willing to gamble on a variable rate to just under 3% if you lock in for five years.

“This is a good news story with clouds on the horizon because it’s a lot harder for rates to go down further and a lot easier for them to go up,” says Jamie Feehely, managing director of Canadian structured finance with DBRS.

The ratings agency lays out what it calls an “interest rate shock” scenario where rates rise two percentage points — an increase that would be hefty enough to leave the average Canadian with more debt than the Office of the Superintendent of Financial Institutions considers acceptable.

That increase in rates would mean the average Canadian household with a conventional mortgage, not insured by the government, would see almost 46% of pre-tax income going towards paying down debt — a level on par with what we saw in the early 1990s when interest rates were double digits. So a two percentage point increase would mean our debt servicing costs jump by six percentage points.

Under OSFI guidelines the measure called gross debt service ratio should be 40% or as high as 45% if you are stretching it, according to DBRS. At 46%, consumer would have trouble qualifying for a mortgage, meaning many potential new buyers would be left on the sidelines.

 The impact wouldn’t be immediate for existing Canadian homeowners because once you have a mortgage that test only comes into play if you decide to switch lenders.

“We really do believe rates will go up, it’s just a question of when,” said Mr. Feehely.

The ratings agency does not expect a sharp rise in mortgage defaults which averaged 0.32% of loans in 2013 compared to 1.43% in the United States. Even when unemployment spiked during the 1990s, Canadian mortgage defaults did not reach 1%.

Canadians also have plenty of equity in their homes. The average Canadian household has $560,800 in net worth, including $189,400 in their home. Net worth as a percentage of disposable income reached a record of 715% in the first quarter.

While the banks may be protected in case of default, the consumer might not be as lucky. “On average the Canadian household is stretched,” says Kevin Chiang, senior vice-president of Canadian structured finance with DBRS, adding the worry is what happens if there is an external shock to the Canadian economy.

Benjamin Tal, deputy economist at Canadian Imperial Bank of Commerce, says while he worries about a hike in rates, Canadians are probably in a slightly better shape than they were in the 1990s to absorb an increase because heavy discounting off the posted rate has left us with a cushion.

He adds any rise in interest rates would also probably come with a jump in income as inflation kicks in so everything would be relative.

“The key issue will not necessarily be a wave of defaults but a reduction in consumer demand,” said Mr. Tal, adding that’s why he’s forecast a rise in interest rates will slow the housing market down.

Jeff Schwartz, executive director of Consolidated Credit Counseling Services of Canada Inc., said while the amount of interest may be low, the rising debt will be a problem.

“Canadians are just buying too much house, we should be worried,” said Mr. Schwartz. “Even though interest rates are low, the amount of money we have to pay overall to our income is incredibly high.”

 National Post