The Bank of Canada is widely expected toagain next week to combat inflation, possibly by as much as , a move that could cool home prices and put pressure on indebted consumers.
While much of the recent focus on Canada’s residential real estate market has been on soaring prices and lack of affordability — issues that are expected to be addressed in Thursday’s budget — less attention has been paid to what a combination of rising rates and falling home prices would mean for households that have been borrowing cheaply on lines of credit secured by their homes, also knowns as HELOCs.
“Because HELOC interest rates are variable, rising interest rates could make the cost of borrowing much higher than when a borrower withdrew money,” said Michael Toope, a spokesperson for the.
“This could put pressure on a borrower’s ability to pay down the (credit line), while also having to manage other expenses.”
Regulators are already on high alert concerning a popular loan product offered by major financial institutions that combines both a mortgage and a secured line of credit because the loan can be up to 80 per cent of the home’s value, compared to 65 per cent on a traditional secured line of credit.
The Office of the Superintendent of Financial Institutions has been keeping an eye on these popular loan products and how the banks handle them because they now represent a significant portion of Canada’s uninsured household mortgage debt.
Peter Routledge, OSFI’s superintendent, highlighted a “tail risk” associated with the combined loan product in a January speech, noting that it “dynamically re-advances” credit to mortgage holders as they pay down their home loan. He was building on comments he made in a speech late last year, in which he pointed out that borrowers can elect to pay only the interest on these lines of credit, and even use them to pay their mortgages “in times of financial distress.”
Routledge, a former bank analyst and Finance Department official, cautioned that such “non-traditional housing-backed products can lead to greater and more persistent outstanding principal balances, increasing risk of loss to lenders.”
In his January speech at RBC’s Capital Markets Canadian Bank CEO Conference, Routledge suggested OSFI was considering changes to its B20 Guideline, which instructs the banks on practices and procedures for residential mortgage underwriting, to make sure banks are meeting OSFI’s expectations for combined mortgage and HELOC loan products.
Non-traditional housing-backed products can lead to greater and more persistent outstanding principal balances, increasing risk of loss to lenders
In response to questions about the impact of a potentially softening housing market, an OSFI spokesperson said a decrease in house prices “would not necessarily trigger any action” on the part of the banks.
“However, as per B20, OSFI expects that (financial institutions) should review the authorized amount of a HELOC where any material decline in the value of the underlying property has occurred and/or the borrower’s financial condition has changed materially,” she said, adding that this expectation also applies when a HELOC is part of a combined loan product with a mortgage.
The features have made combined loan products a popular choice, particularly with interest rates at record lows in recent years and no obligation to pay anything but the interest on most of the borrowing.
According to figures compiled by the, combined mortgages and HELOC products grew to $710.3 billion at the end of last year, representing 41 per cent of total real estate secured lending. Their share rose from 37 per cent in the first quarter of 2019.
It’s “quite substantial,” said Jason Mercer, a vice president and senior analyst at Moody’s Investors Service.
While borrowing above 65 per cent of a home’s value is usually subject to amortization over a set term like a traditional loan, the analyst noted that the amount in these combined products that is not amortized — meaning it is treated like a conventional home-equity line of credit where only the interest must be paid and there is no set term for the loan — is now double the size of standalone HELOCs.
Mercer said banks track loan-to-value at two points, when the home is purchased and again if there is an updated property appraisal, which can trigger an increase in borrowing limits if house prices have risen.
Falling house prices could lead to problems, he said, but not right away. First of all, there would be a 20 per cent equity buffer before borrowers were under water. And the problems would only materialize if they sold the home.
“Even if the mortgage value was above the value of the house, borrowers who live in their house likely wouldn’t sell it and realize a loss,” Mercer said, adding that those who remain employed are likely to continue to make monthly payments.
Still, the Financial Consumer Agency of Canada has expressed concern about how HELOCs are being used since 2018, after finding that a substantial number of Canadians were paying only the interest, leaving the principal amount subject to rising interest rates.
One observer suggested the interest-only model is akin to a credit card, although the interest rates on secured lines of credit are markedly lower.
The popular credit lines secured against a home can be used for large house-related expenses such as renovations, but there is no requirement to use the money for any particular purpose and balances are subject to prevailing interest rates. And while many borrowers don’t realize it, full repayment of the loan can be called any time by the bank, unlike a traditional mortgage.
Back in 2018, FCAC flagged “a pressing need … to help Canadians realize that not using HELOCs responsibly can have serious repercussions on their financial well-being.” Concerns about consumer exposure to rising rates have only increased since then.
Clara Vargas, senior vice president of Canadian structured finance, at DBRS Morningstar, said rising interest rates will add risk and uncertainty, particularly to loan products that combine mortgages and HELOCs.
But she said the risk of default on such debt — which could hurt the banks — is mitigated by factors including tight underwriting standards that include stress tests, along with a recovering labour market and recent property value appreciation.
Vargas said that if house prices fall, borrowers who find themselves in arrears could find they are unable to generate proceeds sufficient to repay the mortgage and other house-related debt.
“However, the risk is more correlated to unemployment and would also depend on how much equity there is in the property,” she said.
On a national level, Vargas said the real estate equity ratio has increased to 76.5 per cent from 72.3 per cent two years ago, which includes homes that have already been paid for in full.
House prices could come under pressure on a number of fronts. Thursday’s federal budget is expected to contain measures aimed at improving housing affordability, with CTV News reporting Wednesday that they will include a countrywide, two-year ban on foreign buyers.
Next week’s Bank of Canada interest rate announcement is also being watched closely.
James Laird, co-founder of Ratehub.ca and president of CanWise Financial mortgage brokerage, is among those expecting a significant rate hike of 50 basis points on April 13.
He said an increase of that size on the heels of the March 2 rate hike — the Bank of Canada’s first in more than three years — would have a “cooling effect on home prices” across the country and a significant impact on variable rate mortgage holders.
Anyone with a variable rate mortgage should … budget for additional rate increases totalling one to two per cent for the remainder of the year
“Anyone with a variable rate mortgage should … budget for additional rate increases totalling one to two per cent for the remainder of the year,” Laird said.
Financial institutions tend to raise their prime rates in tandem with Bank of Canada hikes, though they don’t always match them. When the overnight rate was raised to 0.5 per cent last month, Canada’s two largest banks quickly raised their prime rates to to 2.7 per cent from 2.45 per cent.
Those paying fixed rates aren’t immune, with many fixed-rate mortgages having to be refinanced each year as their terms come to an end. And, as Laird noted, fixed rates have already increased by 1.5 per cent as bond yields priced in the anticipated Bank of Canada rate increases.
Avery Shenfeld, chief economist of CIBC Capital Markets, said the country’s strong economy should help cushion borrowers — at least for now.
“We’re not yet in territory where we would expect to see a lot of financial stress, particularly with such high employment rates,” Shenfeld said. “But each bump higher will be a step to slowing the growth in demand for additional borrowing by Canadians.”
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