Recently, people near and dear to my heart bought a new home. I was more than thrilled for them since their new place is lovely and will be a perfect nest for their growing family. And as they disclosed their numbers to me, I started to think about the impact that the rising mortgage rates will have on them when they go to renew their mortgage in 5 years. I’m fervently hoping that they are not underwater on their mortgage when it comes time for them to renew. The new reality in Canada is that if homeowners are underwater on their mortgages at renewal time, then there is precious little incentive for their lender to give them a preferential renewal rate.
What does it mean to be underwater on your mortgage?
You are underwater on your mortgage if the mortgage debt outstanding is higher than the market value of your home.
For example, if you owe $250,000 on your mortgage and the market value of your home is $200,000, then your mortgage is underwater by $50,000.
What is the stress test?
The Canadian government introduced a mortgage stress test to assist borrowers to determine if they could afford their mortgage if rates were to increase 2% above the posted 5-year rate. If the posted rate is 3.49%, then the person seeking a mortgage has to demonstrate she can still service the mortgage at rate of 5.49% (= 3.49% + 2%).
If you want to read the nitty-gritty details, here is the link as of the time of writing: How the Stress Test Works.
The short and sweet of it is this: if you cannot show that your finances could not support a mortgage at a rate 2% higher than the bank’s posted rate, then you cannot get the mortgage amount that you want.
Why does it matter if you’re underwater on your mortgage?
Being underwater matters when it comes time to renew your mortgage. Banks and other mortgage lenders are not keen to renew mortgages where the underlying asset, i.e. the property, is worth less than the debt. They reasonably and rightly understand that there is less incentive for a homeowner to pay the full price of the debt ($250,000) for something that is worth less than the debt ($200,000).
However, let’s assume that you want to stay in your home even though you’re underwater on the mortgage. The lender may not offer you the best rate since there’s less chance that you’re going to switch to another mortgage holder. Before the lender releases title on your property to another lender, you as the homeowner have to pay off the mortgage. But you’re underwater by $50,000 (= $250,000 – $200,000).
Another lender is not going to give you a mortgage of $250,000 on a property that is worth $200,000. Secondly, lenders want homeowner to have some skin in the game so they generally want to see homeowners put down 20% of the value of the home. In this case, the next lender would only advance a mortgage of $160,000 (= 20% x $200,000).
As the homeowner, you would have to come up with $90,000 to get a mortgage from another lender. That $90,000 would cover the difference between the debt owed to your current lender, again $250,000, and the amount of money that your next lender would give you, $160,000, on your home which now has a market value of $200,000. Another way of looking at is that you’d have to come up with $50,000 to pay off your old lender and another $40,000 as a 20% equity stake in order to get financing from your new lender.
If your current lender is aware that you don’t have $90,000 kicking around, then your current lender has no incentive to offer you a rate that is lower than the posted 5-month rate. In other words, they’ve got you by the short and curlies. Why on Earth would your lender offer you a lower rate if they don’t have to? The only reason that your lender offers you “their best rate” is because they don’t want you to get a mortgage with one of their competitors. If there’s no chance of you leaving, due to that pesky problem of not having an extra $90,000 lying around, then your lender has no motive to charge you less interest on your mortgage.
The second reason to not be underwater on your mortgage is that the new lender is going to subject you to the stress test. Not only do you have to come up with the down payment amount of $40,000 and another $50,000 to satisfy the deficiency between your mortgage debt and the market value of your home, you have to demonstrate to the new lender that you can afford the new $160,000 mortgage at rate that is 2% higher than the posted rate. If you can’t pass the stress test, then the new lender is not going to issue you a mortgage and you’re stuck with your current lender.
How to obtain good options for renewal time
You want to be in the position of having good options come renewal time. When it comes to mortgages, one of those good options is knowing that you can switch lenders if you need to. Once your current lender is convinced that you have the ability to take your mortgage business to their competitor, they will again be incentivized to give you a discounted mortgage rate, which is simply a mortgage rate that is less than the posted one.
In short, the discounted rate is a sweetener that is offered so that you have a good reason to stay with them. They know that it is easier to keep a current customer than it is to find a new one.
The main way for you to become a customer that they want to keep is by ensuring that you are making all of your mortgage payments on time and that your mortgage debt remains lower than the market value of your home. You cannot control what the residential market does, but you can control how much money you put towards your mortgage every time you make a payment. Using mortgage prepayment options means that you are eliminating your mortgage debt as quickly as possible.
I firmly predict that as mortgage rates continue to rise over the next 5 years, there will be many people who will not be in a position to move their mortgage to another lender due to being underwater on their mortgages, becuase they cannot pass the stress test, or both. The end result will be that these mortgage holders will not be offered discounted mortgage rates by their current lenders. In turn, this means that they will be required to make higher mortgage payments after renewal or else face foreclosure by the bank.
Do what you can right now to pay down your mortgage as quickly as possible so that you maintain the desirable position of not being underwater on your mortgage and ensuring that you will be offered the option of being offered a discounted mortgage rate when it comes time to renew your mortgage.