Residential Mortgages – A lesson from Canada

Thanks to the recent economic meltdown, the U.S. mortgage industry – and its lax standards in residential lending – has been the subject of intense scrutiny. The debate has led to the question: where do we go from here?

It might be helpful to look north, given that our Canadian neighbor’s residential mortgage lending industry didn’t get out of whack like ours did here in the U.S.

According to an article in the Financial Times on January 19, 2011, Canada’s home-finance system is more conservative than the one in the U.S. For starters, most residential mortgage lending is handled by large domestic banks. When loans are made in purchase and sale transactions, the banks are required to buy government insurance if less than 20% of the purchase price is put down. The result? Subprime and other high-risk mortgages amounted to a small part of the Canadian housing market.

Also, the impetus for Canadian homeowners to borrow as much as possible isn’t as great as in the U.S. because interest paid on residential mortgages in Canada is not tax deductible. Although suggesting that kind of revamp in the U.S. might cause an outcry in several quarters, some members of the U.S. Congress have suggested taking away the interest deduction would be a welcome double-whammy by curbing U.S. borrowers’ appetite for debt and reducing the U.S. deficit.

Because during the downturn Canada’s economy remained much more robust than the U.S.’s, housing prices have continued to rise despite Canada’s mortgage lending controls. But as of January 17, 2011, the controls were deemed not tight enough. So the Canadian government imposed even stricter lending standards, reducing the maximum amortization term to 30 years.

As a further protection to homeowners, home equity loans (which typically have variable interest rates that can spiral upwards) are now capped at 85% of loan-to-value (down from 90%). What’s more, the Canadian government will no longer insure home equity loans, meaning banks are now on their own if they expect to be repaid by borrowers.

And that lack of insurance protection, according to the Canadian finance minister, will place risk evaluation squarely on the shoulders of lenders instead of taxpayers.

Food for thought.

- Morrie Erickson